What Is an Arm's Length Transaction?
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How an Arm’s Length Transaction Works
In an arm’s length transaction, both parties are acting independently from the pressure of a pre-existing relationship and they have equal access to the necessary information for the deal to proceed. As such, neither party offers a price higher or lower than what they perceive is fair regarding market conditions.
An arm’s length transaction is another way of describing a regular, legitimate sale of real estate. Self-interest rules both parties and the buyer is trying to offer the lowest possible price while the seller is trying to get the highest possible price in the sale[2.
Why Arm’s Length Deals Matter
Arm’s length deals in real estate help ensure that the property was sold at its fair market value. For the sake of transparency and fair valuation, it is essential that all parties in the transaction establish that a deal is done at arm’s length and if not, it should be disclosed to the lender and the property tax assessor as a non-arm’s length transaction.
An arm’s length transaction also effectively sets a price benchmark on comps, because it is considered a normal sale where the value is indicative of the property’s true value. Such a transaction contributes to fair business practices among property sellers and buyers. It also helps protect the public from pricing inaccuracies in the real estate market.
The taxing authorities will also be on the lookout for any price manipulation to minimize the tax levied on the transaction. The seller’s capital gains tax and the buyer’s future property tax obligation will hinge on the sale price.
Arm’s Length Transaction vs. Non-Arm’s Length Transaction
On the other hand, a deal between two parties with an existing relationship as the foundation for a deal is called a non-arm’s length transaction. The connection or relationship between the buyer and the seller may tilt the transaction in favor of one party over the other. As a result, the pricing in the deal can either be overvalued or undervalued, far from genuine market values.
The contracting parties to a non-arm’s length transaction can involve:
- Members of the same family.
- A parent company and its subsidiary or affiliate.
- Principal business owners and their family members.
- An entity’s management and members of their family.
- Wards and their legal guardians.
- Trustees and trust beneficiaries.
- Employers and their employees.
Why Do Lenders Care About Arm’s Length Transactions?
Basing a transaction on fair market prices is generally better and advisable, according to most lenders. However, an arm’s length transaction may still involve unfair practices. Here are three potential issues in an arm’s length transaction.
1. Inflated Appraisal
An arm’s length deal between a buyer and a seller may look good on paper, but the buyer may overpay for an inflated price if the seller colludes with an appraiser. The appraiser, in this case, artificially inflates the cost, causing overpayment for the buyer and overfunding for the lender.
This overpricing can happen with the seller making some inexpensive home improvements to mask the inflated appraisal. Consequently, the buyer overpays, and the lender is left with collateral worth much less than the loan.
2. Short Sale
Lenders are exceptionally vigilant on pre-foreclosure short sales involving parties presenting the transaction as an arm’s length deal. Should the parties be related, such virtual arm-in-arm transactions would defraud the lender.
This fraud occurs because property in default is being sold for less than what the owner-borrower owes on the mortgage. As a result, the lender falls to a losing position of recouping the loan at a pre-foreclosure sale price that is less than the loan balance.
With a relationship in the transaction, the lender’s concern is that the buyer will eventually transfer the property title back to the seller. Hence, banks generally prohibit short sales between related parties.
Lenders become suspicious of parties who may inflate the home selling price and seek financing for the sales transaction. Such fraudulent transactions involve buyers borrowing to purchase an overpriced property from a related seller. Then, the buyer lets the property go into foreclosure and splits the proceeds from the loan with the seller.
How to Avoid Arm’s Length Deal Issues
Due to the risks of fraud associated with related parties’ real estate deals, lenders require a host of items to establish that transactions are done at arm’s length. These requirements include the following:
- A copy of the sales contract between buyer and seller.
- An independent property appraisal.
- An affidavit of arm’s length transaction disclosing the parties’ relationship.
How to Pursue a Fair Non-Arm’s Length Deal
While many lenders restrict non-arm’s length transactions, there are certain ways to pursue this type of sale in a way that is fair and aboveboard. Below are some tips for completing a fair non-arm’s length deal that lenders may accept:
- Have a third party compare the terms of the contract with those of similar transactions of unrelated parties.
- Ensure that the current property owner is not behind mortgage payments, a risky oversight when selling property between family members.
- Hire an experienced real estate agent or an attorney for professional representation in the sale.
- Hire a title company to guard against any unpaid debts attached to the property.
An arm’s length sale seeks to achieve the fair market value for property, following or setting market benchmarks for pricing. Lenders look to establish if a real estate transaction is arm’s length or not. Navigating these rules requires the professional help of either a real estate attorney or a real estate agent.
While many lenders avoid a non-arm’s length deal if possible, there are some ways to pursue one if certain rules are followed. This track, however, will require extra care and consideration to minimize, if not eliminate, the risks of such a transaction.
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