Arm’s length transactions may sound like something that has to do with buying shirts, but they’re a big part of the real estate business. So what is an arm’s length transaction? Turns out, it doesn’t mean you’re any less involved in buying or selling a home. In fact, this real estate term actually means you’re going about the transaction in a fair and legitimate way. Let’s dive into the details below.
What is an arm’s length transaction?
In real estate, an arm’s length transaction is when the buyer and seller each act in their own self-interest to try to get the best deal they can. In most sales, a seller is trying to make a large profit, while the buyer is trying to pay the least amount of money possible. To resolve this discrepancy, both sides agree to meet in the middle and sell the home for its fair market value. In fact, this is how most real estate transactions play out.
Defining what doesn’t count as “arm’s length” is a bit trickier, because it’s hard to identify whether or not someone is acting in self-interest or in the interest of someone close to them. That said, generally, any relationship where one party is felt to have significant power over the other or where the two are close enough to work together in their joint interest is seen as a red flag.
Here are some common examples of deals that are not arm’s length transactions:
- Sales between family members or friends
- Sales between an employer and his or her employees
- Sales between a parent company and one of its subsidiaries
- Sales between a trust and its beneficiaries
Effects of non-arm’s length transactions
On a personal level, a non-arm’s length transaction can have significant tax implications for both the buyer and seller. Be sure to consult a tax professional, because the sale will be taxed differently depending on whether the transaction is considered a gift, like-kind exchange, or capital gain.
Just to be clear: In and of itself, a non-arm’s length transaction is not illegal, nor is it necessarily a bad idea. It just comes with some extra red tape.
What to remember in non–arm’s-length transaction
First and foremost, both the seller and the buyer will be expected to be upfront and honest about the nature of their relationship. Usually, an affidavit is drawn up to document these details in writing.
“The affidavit states that no party shares a business interest with the mortgagee,” says Terrylynn Fisher, an agent in Walnut Creek, CA. “Furthermore, it says that there are no hidden terms or special arrangements between the buyer and seller, or their agents. Special arrangements could include money, kickbacks, gifts, and/or understandings to move back in or stay in the property.”
In addition to the signed affidavit, the mortgage company may also require a comparative market analysis and appraisal to be conducted by an independent authority to ensure that the property is being sold at fair market value. As long as you comply with their stipulations, your non-arm’s length transaction should go smoothly.
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