Arm’s Length Transaction - What The Heck Is It?

A person's arm with an arm's length transaction tattoo in front of a house for sale.

If you're not familiar with the term, you may be wondering what an arm’s length has to do with the sale of a home? Well, this is the United States, and we do use feet to measure distance, so… Maybe the arms sounded like logical choice when the phrase was first coined; who knows?

I’m not sure where the term originated, but it’s become a means of describing how close (relationship, not distance) the parties of a transaction are to each other. These days, whether or not the sale of residential property is an arm’s length transaction must be disclosed, and it may even impact the terms of the sale. It may also be referred to as arm’s length negotiation, depending on who you’re talking to.

Definition Of An Arm’s Length Transaction

When it comes to buying and selling real estate, an arm’s length transaction is one where the parties involved in the contract have no relationship to each other that would otherwise influence their decisions during the purchase/sale of a property. A “relationship” can include: family members by blood, family by marriage, business associates, beneficiaries, or even parties that share a common business interest with each other.

In an arm’s length transaction, all parties are considered to have equivalent bargaining positions, a clear mind, and equal knowledge of the property being sold. Without the presence of a pre-existing relationship or undue duress, it’s determined that buyers and sellers will act in their own best interest. This also means, pressure or coercion from the other parties, does not exist.

When an arm’s length transaction occurs, the resulting sale should properly reflect a home’s true market value. Since taxes and fees are based on a property’s sale price, the government has a vested interest to ensure transactions are at arm’s length. Even more importantly, an arm’s length transaction helps protect lenders and deter mortgage fraud.

In addition, the sale data produced from these type of transactions will be used by real estate agents, appraisers and tax assessors to more accurately determine current market trends & comparable home values… so it’s important they reflect actual market conditions.

Non-Arm’s Length Transactions

When the sale of a home occurs and two or more parties have a pre-existing personal or business relationship that may create a conflict of interest, you have a non-arm’s length transaction. This may also be referred to as “identity of interest”. In a situation like this, the property’s sale price typically differs from the going market value, and the loan may be considered a higher risk by lenders. Due to the high probability of kickbacks, straw borrowers, pumped-up sale prices, fraud, and other negative influences, lenders must scrutinize these loans more closely.

Lender Restrictions & Requirements

When a borrower is seeking FHA financing in a non-arm’s length transaction, a much higher down payment is usually required. Instead of borrowing up to 96.5% of the value of the property, a buyer may only be eligible for up to 85% LTV (loan to value). At some point during the transaction, buyer(s) must complete an Identity of Interest Certification to disclose any relationships; so it’s smart to go ahead and be upfront about any conflict of interest that might exist. Keep in mind, when it comes to short sales, FHA prohibits any relationship.

VA loans also have restrictions on non-arm’s length transactions, usually only applicable in specific situations. For instance: construction to perm loans. There may be other circumstances that would prohibit the Veterans Administration from backing the loan, so it’s best to work with a knowledgeable loan officer and disclose any relationships up front.

Conventional financing underwritten to Fannie Mae and Freddie Mac guidelines also has restrictions on non-arm’s length transactions, but it’s not as strict as with FHA and VA loans. It’s best to review the circumstances with an experienced loan officer prior to moving forward with a purchase… if you’re concerned a relationship does exist. In the event of a short sale, both Fannie and Freddie require an arm’s length transaction affidavit to verify there is no relationship between the parties involved.

Arm's Length Transaction Affidavit

In the event of a short sale, the lender(s) holding the mortgage of the property being sold, usually require an arm’s length transaction affidavit be completed. The affidavit must be signed by all parties, including the: buyer(s), seller(s), real estate agents and closing attorney. This document states that there are no hidden/implied terms or special understandings between the parties that have not been included in the contract or otherwise disclosed. Falsifying information on this form could leave you liable for mortgage fraud… so don’t do it!

The affidavit also includes stipulations that prevent the buyer or seller from receiving any proceeds from the sale of the property. This also extends to the seller’s real estate agent, who may not be relative or business associate and receive compensation from the sale. With a short sale, the seller essentially hands over the keys to the buyer and walks away with nothing. Additionally, the seller is not allowed to inhabit the property after the closing. This means the home can’t be sold (or rented) back to the seller at any point after the short sale has been finalized.

Buying A Home From A Friend Or Family Members

So what if someone you have a “relationship” with owns a property you’d like to buy? In this case, you’d need to make sure you clearly disclose the relationship to all parties by stating it in the contract. In Georgia, the standard purchase and sale agreement produced by the Georgia Association of REALTORS® has a section on the first page for this. The section reads:

Language from the purchase and sale agreement disclosing any relationships between parties.

As mentioned earlier, a non-arm’s length transaction will likely limit the financing options for the buyer, but it could also create tax ramifications for both parties. Buyers and sellers involved in a potential non-arm’s length transaction should work closely with a tax specialist to determine how the IRS will treat their specific situation. For example, proceeds from the sale may be taxed as regular income instead of capital gains; and things like 1031 exchanges may not be permitted.

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