Arm's Length Transaction: Everything You Need to Know
An Arm's length transaction is when buyers and sellers have no relationship to one another and can act independently and for their self-interest.5 min read
What Is an Arm's Length Transaction?
"Arm's length" refers to a legal transaction in which buyers and sellers of products or services have no relationship to one another either by blood, marriage, or business dealings. Without a relationship, buyers and sellers can act independently. Without previous ties, an arm's length transaction makes sure neither person feels pressured by the other or acts in connection with one another.
The idea of an arm's length transaction, also known as an arm-in-arm transaction, came about in the real estate market as a way of handling tax authorities. Generally, family members and businesses with related shareholders are not acting at arm's length, which can cause ethical problems. Such ethical issues include a company's supervisor who forces an employee, under the threat of termination, to buy real estate using the boss's name.
In the 1997 case McNichol et al v. The Queen, the tax judge suggested three tests or criteria to be used when deciding whether individuals involved in legal cases act at arm's length. These tests include:
- A common mind directing the negotiations and bargaining for both parties in the transaction
- Parties acting in concert without separate interests
- De facto control
One question can summarize these points: Does one individual have control over another? If so, the transaction is not considered at arm's length.
Why Is an Arm's Length Transaction Important?
An arm's length transaction serves as a basis for figuring out fair market value (FMV). This value is the estimated price of a property based on what a buyer would pay based on values in the current real estate market.
When trying to decide a property's market value, an arm's length transaction is necessary to find the right price. If not, the agreed-upon purchase price could be different from the property's actual fair market value.
Arm's Length Examples
When a homebuyer purchases a house from a seller, the negotiated purchase price is more likely to be close to market value. The reason is that the buyer wants to keep the price as low as possible, but the seller wants the highest possible price. Each person involved in this real estate transaction has equal bargaining power.
When family members become involved, the result can be different. Parents who sell their house valued at $250,000 for the bargain price of $150,000 to their child is one example. The transaction won't likely produce the same result if it occurred between two people with no relationships between them.
A real estate transaction directly impacts financing, local taxes, stamp duty, and other factors. This transaction also sets comparable prices on the market, which is why maintaining arm's length transactions is so important. A non-arm's length transaction is a higher risk to lenders because of possible inflated sales prices, unsupported values, and misrepresentation. As such, qualifying for financing if you're purchasing a home from a relative can be more difficult.
In fact, FHA (Federal Housing Administration) loans require an 85 percent "Loan-to-Value" (LTV) ratio in a non-arm's length transaction. The term LTV gets used in risk assessment to express the ratio of the loan to the value of the asset being purchased. In some cases, the 85 percent LTV can be waived if the buyer has lived at the property for six months or more before the purchase. Other exceptions include one of a home builder's employee buying a house.
Arm's length transactions are also important to prevent real estate transactions under coercion. If someone gets forced to sign an agreement under duress, the transaction won't hold.
Another example is when one person lacks the capacity to participate in the transaction. An example of this situation involves a parent trying to conduct a transaction with a minor child. An arm's length approach essentially protects you from buying or selling real estate against your will.
What Could Happen If You Buy Property in a Non-Arm's Length Transaction?
A non-arm's length transaction often has tax consequences. You could be hit with more taxes resulting from a real estate transfer occurring at less than fair market value. If you're considering a short sale purchase, you should consider tax penalties.
However, short sale lenders often require individuals to sign an Affidavit of Arm's Length Transaction, which states that all people involved are unrelated to one another. This document ensures that everyone is acting in the best interests to complete the transaction at a fair market price.
Arm's length requirements in Short Sales have some of the following issues:
- Short-sale lenders don't allow real estate agents to list their own properties as short sales.
- Short-sale lenders don't allow a real estate agent related to the seller to list the property.
These lenders demand that all people not be associated through family or business to get a true fair market value. As such, FHA buyers and those considering a short-sale transaction should be aware of these conflicts. Disclose any conflicts of interest early in the process; otherwise, you could risk losing the real estate.
In the case of family transactions, the law will check to make sure the property gets sold at fair market value and that all facts are correctly represented. If a seller wants a relative to buy a home below market price, the transaction could be considered a gift instead of an arm's length transaction.
Frequently Asked Questions
- What is fair market value?
In basic terms, fair market value (FMV) is a reasonable price a buyer would pay and a seller will accept. Fair market values fluctuate depending on the real estate market, which is why making comparisons to recently sold homes in the area is important.
- I want to buy a property from family. Can I avoid the problems arising from a non-arm's length transaction?
In most cases, you can, but you must be smart about your approach. Appointing an independent person is one solution in business transactions. Buying or selling at the proper price is essential. You'll also need to affirm that all people can complete the transaction without doing something against one's will.
- Is a transaction between spouses considered non-arm's length?
Yes. Legal context consider family to be people related to one another by blood or marriage. This relation includes spouses, in-laws, and nieces or nephews through marriage. Even non-related business associates wouldn't be considered strangers under the law, and therefore couldn't conduct transactions at arm's length.
- How can I buy property from a family member without running into issues?
If you're getting your mortgage through the FHA, you will need to complete an Identity of Interest Certification. This certification is required whether you're related by blood or connected through a business relationship. When an identity of interest exists, you must state that you understand your loan-to-value ratio gets restricted by 75 to 85 percent.
- What is a loan-to-ratio (LTV) value?
The loan-to-ratio value is a financial term expressing the ratio of a mortgage to the asset's value. The higher the loan-to-ratio value, the riskier the loan is for the lender.
Do You Need Help Determining an Arm's Length Transaction?
Whether you're buying or selling a home or business, you need to follow certain steps to avoid tax penalties and other issues, especially true when you have family involved. To avoid potential issues, post your questions to UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies such as Google, Stripe, and Twilio.