Arm’s Length Transactions in Real Estate

The PropertyClub Team
Jul 8th 2020
The majority of real estate deals are arm's length transactions, where each party acts in their own self-interest. So what exactly does this mean and why is it important?

In the world of real estate, complicated and complex situations can sometimes come with the territory. While this can be so often confusing, especially if you are a new investor or have not previously been involved in purchasing a property, understanding the ins and outs of different types of transactions is essential. Fortunately, the terms “arm’s length transaction” and “non arm’s length transaction” are relatively simple to understand, and with proper guidance can be navigated without concern.

What is an arm’s length transaction?

An arm’s length transaction is, simply put, a transaction in which there is no close relationship between the buyer and the seller. It suggests that both parties act independently of one another, have little or no influence over each other, and act primarily in their own best interest. During an arm’s length purchase, it can be assured that the buyer and seller are not subject to any pressures from the other party. Generally speaking, members of an arm’s length transaction fall into the following categories:

  • Both parties involved have no prior relationship with one another, particularly no familial or friendship ties.
  • A sale between family members or companies with related shareholders would not be considered an arm’s length sale. 
  • The primary objective of an arm’s length transaction is to ensure that properties are priced at fair market value.

Why are arm’s length transactions important in real estate?

Assuming that both parties have equal information about the concerned property, an arm’s length transaction usually ensures that the property will be sold at as close to fair market value price as possible. Think about it; the seller will want to get the highest possible price for the property, and the buyer will be interested in striking up a deal and getting the home for a lower price. What this typically means is that the agreed-upon sale price will land closer to fair market value than it would if the buyer and seller knew each other and came to some sort of negotiation. Because of this, it also makes it significantly easier to accurately estimate the taxes due on a property, since they are usually based heavily on the fair market value.

What is a non arm’s length transaction?

Obviously, you can then deduce that a non arm’s length transaction is precisely the opposite. This is a transaction in which the seller and buyer have some sort of prior relationship, whether that be familial, friendly, or a business partnership. While this doesn’t necessarily mean that the sale will be questionable, it does potentially leave more room for some form of manipulation or negotiation. The primary concern with non arm’s length transactions is the likelihood that they can create a hotbed for fraud or tax evasion.

Furthermore, a non arm’s length sale can mess with the fair market value of a property because of the higher likelihood that the buyer and seller will strike some sort of a deal between them. 

Non arm's length Transaction Example

John decides to put his house on the market and lists it with a sale’s price of $280,000, which is in line with the fair market value of the home. An unknown buyer puts in an offer on the house for $275,000. If John accepts this offer, the home will sell for a reasonable price, and the fair market value would remain true. This would be considered an arm’s length sale since the seller and buyer have no prior relationship.

However, John’s son expresses an interest in buying his father’s house, but unfortunately, he can’t afford to pay the asking price of $280,000. Since it’s his only son, John wants to see the house go to him, so he decides to strike a deal that will enable his son to purchase the home. John agrees to sell the home to his son for $200,000, $80,000 below the asking price. The sale goes through, and the fair market value of the home has now been skewed. This would be considered a non arm’s length transaction.

The primary problem with a non arm’s length sale tends to be a mortgage lenders’ reluctance to finance the transaction. Lenders might decide to take extra precautions in these situations as a way of protecting themselves against potential fraud or scams. It should also be noted that a non arm’s length transaction can also have the potential to harm a personal relationship, and so should be handled with the utmost care and consideration.

While a non arm’s length transaction might leave the door open for complications, it can be done fairly. Below are some tips for completing a fair non arms length transaction:

  • Make sure that the current owner of the property is not behind on their mortgage payments. This could be a risky oversight when selling property between family members.
  • It’s best to hire an attorney or experienced real estate agent to help you deal with the sale. While a non arm’s length transaction is completely legal and can be done fairly and with good intention, it’s a good idea to have proper representation should there be some sort of oversight.
  • Hire a title company to protect against any unpaid debts that might be attached to the property.

While an arm’s length sale is more common and, in many ways, easier to navigate, that certainly doesn’t mean that a non arm’s length sale can’t go smoothly. It just means that extra care and consideration should be made to ensure that both parties are content and that the sale is completed legally and without potential risky consequences. If you are unsure about how to correctly handle a sale where there is a relationship between buyer and seller, it’s best to seek legal or expert advice.