The bank won't accept my 401K because of the cash-out options, nor accept gift/borrowed funds.  

They can give you a gift of equity to pay for the down payment.

Second, as others have stated (I have no personal experience with this) the 97% LTV sounds like a gift from the heavens!  

At best, the way you're currently going about this will require you to pay income tax on the money he's sending you (minus about 15k of tax-free gift money), and at worst you're (albeit unknowingly) committing fraud here. 

Buy the Home Improvement gift cards at Office Depot/Staples. 

Hi everyoneAnother question for you guysMy lender told me that the down payment and closing costs have to be your own money they cannot be gifts.

I read that my father would be able to give me a gift of equity to make up the difference and also account for the 20% down payment, thus avoiding pmi.

Purchase Lowes/Home Depot Gift cards at two venues, a.

My wife's is First of Oct. they are now saying she can't do loan on her own because the money from my 401k would be considered a gift.

Something else to consider is if you pay off the mortgage for them and they gift you the house, are you responsible for paying capital gains taxes when the property is sold?