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Buying and selling real estate can be complicated. Two types of transactions that are important to know about are arm's length and non-arm's length transactions.
Lenders prefer arm's length transactions, and typically there are restrictions and greater levels of scrutiny for non-arm's length transactions, so knowing what to expect can really help smooth the bumps in your real estate deal. Let's explore what this means for you.
Real estate transactions involve multiple parties. When the buyer and seller have no close relationship with one another, the transaction is considered an "arm's-length" transaction. Both parties act independently of one another and in their own self-interest. This helps ensure the transaction is fair and objective. Each party has the same information and neither the buyer or seller have an advantage over the other.
In an arm's length transaction, such as a home purchase from a stranger, both the buyer and seller are trying to get the best price possible. The seller wants to sell at the highest price and the buyer wants to buy at the lowest price. As both parties negotiate, the transaction price will typically be close to the fair market value of the property.
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A "non-arm's length" transaction, also known as an "arm-in-arm transaction," is where the buyer and seller have a relationship with one another. The relationship can be personal or professional, such as family members, business partners, or close friends. Close relationships can lead to prices not in line with fair market value of the property and, in extreme cases, even fraud.
One example is a parent selling real estate to a child. The parent may want to sell the property at a deep discount in order to avoid paying taxes or to simply give the child a great deal on their first home. As a result, the transaction price of the property in this example is below fair market value. Another example of a relationship is two subsidiaries of the same parent company engaging in a real estate transaction. In some cases, both parties can use a non-arm's length transaction to defraud other parties involved in the transaction, such as a mortgage lender.
Lenders are more likely to approve financing arm's length transactions than non-arm's length transactions. Closely related people in real estate transactions can manipulate the price or engage in illegal activity. Lenders, assessors, and other parties have to scrutinize these types of mortgage loans more. There is less suspicion with real estate transactions dealing with non-related parties.
There are potential tax consequences with non-arm's length transactions as well. If a family member or business partner wants to sell the property at a deep discount, then it is called a gift of equity. The gift tax limit for 2023 is $17,000 per person. Any gift over that amount counts toward the lifetime gift tax exemption. In addition, the IRS can impose penalties if a non-arm's transaction is not conducted properly. The IRS will be watching closely to ensure the property is bought and sold at fair market value.
A non-arm's length transaction is not illegal, but will face greater scrutiny since there is greater chance of fraud. As a result, mortgage lenders prefer to finance arm's length transactions. There is also a higher probability that the transaction price is not fair market value. Real estate transactions between related parties must be made with arm's length transaction prices.
One of the benefits of a non-arm's length transaction is lower closing costs. Family members do not have to use a real estate agent and can save the price of commissions. They may save costs on inspections if parties trust each other. There is also flexibility for the closing date of the transaction.
Lenders that offer government-backed mortgages like FHA loans have different guidelines they have to follow for non-arm's length transactions. For example, for an arm's length transaction, the down payment for an FHA loan is 3.5% of the purchase price. For a non-arm's length transaction, however, the down payment must be a minimum of 15%.
There are some exceptions for an FHA loan, such as purchasing the primary residence of a relative, fiancé or domestic partner, or if you are purchasing property that you have rented for the last six months. Each lender will have their own restrictions for non-arm's length transactions, so you will need to talk to the lender for more information.
In a non-arm's length transaction, a family member can take advantage of another member and charge a higher amount than fair market value. Another type of fraud involves short sales. A homeowner who is unable to pay the mortgage may get their lender's approval for a short sale. This means they can sell the property for less than the mortgage.
Lenders favor arm's length transactions because there is less risk of mortgage fraud and similar forms of cheating. For instance, a homeowner who is financially struggling may get a lender's approval to short-sell their property, which means they can sell the home for a smaller value than their mortgage. The homeowner can then pressure a relative to buy the property at the low price and transfer ownership of the property later. The lender takes a loss and the homeowner keeps the property with a smaller mortgage using a non-arm's length transaction.
If you plan on buying or selling property from someone you know or are related to, then you may have to provide additional documentation or undergo an investigation to prove there is no fraud in the real estate deal and that the price is at fair market value. This will also help prevent any legal or tax issues.
The loan terms aren't significantly different between an arm's length and non-arm's length transaction, and that's where the worry is. Since you're still getting the same rate and term as anybody else, the lender wants to be 100% sure it's all on the up and up. You may be asked to bring a larger down payment to closing, however.
If you choose to use a gift of equity as part of your non-arm's length transaction, you'll need to document the gift completely. This includes a gift letter that includes: the amount of the gift, the date the gift is/will be given, that you do not expect to repay the equity gift, and the seller's name and address, and relationship to the buyer. By providing this to your lender, you're being fully transparent about your transaction, which will make everyone feel much better.