Much of the time, buying or selling real estate is complex and involves knowing the other party in the transaction, at least on a surface level. However, this doesn’t have to be the case; with some real estate transactions, the process is short, sweet, and to the point, and neither party really knows the other.
Dubbed “arm’s length transactions,” these deals can help ensure fair market value for a real estate purchase or sale. But before you try to facilitate an arm’s length transaction yourself, you need to know how these transactions work and how they compare to other real estate deals.
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What is an Arm’s Length Transaction?
In a nutshell, an arm’s length transaction is any business deal where the buyers and sellers act independently and don’t influence one another. Most of the time, this also means neither the buyer nor the seller knows one another.
As a result, an arm’s length transaction ensures that both parties act in their own self-interests and aren’t subject to pressure from the other party. In theory, this will ensure that true fair market value will be found and traded upon. The buyer will try to get as low a price as possible, and the seller will try to keep the price high as much as possible.
Because arm’s length transactions are done between two unrelated parties, they comprise the majority of real estate purchases and sales. Simply meeting the other party is not usually enough to disqualify a deal as an arm’s length transaction – you have to have an actual relationship with the other party, such as be related to them, be friends, or be entangled in business affairs.
Note that, for most arm’s length transactions to be legitimate, both parties must have access to the same amount of and quality of information. This ensures that both parties attempt to bid for their own self-interest to the best extent possible.
However, even arm’s length transactions in which one party has an informational advantage over the other still qualify.
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Advantages of Arm’s Length Transactions
Because of their relative anonymity and straightforwardness, arm’s length transactions often have several advantages compared to traditional real estate deals.
Arm’s Length Transaction Tax Implications
For starters, arm’s length transactions often provide tax benefits because it’s easy to estimate tax payments for such deals. Because arm’s length transactions almost always represent the fair market value for a property, taxes are also usually accurate and fair for both parties.
Additionally, the relationship-less nature of arm’s length transactions means fewer opportunities for a buyer or seller to face extra fines (more on this below).
Arm’s Length Transactions Ensure Fair Market Value
The most significant benefit by far is that arm’s length transactions ensure that property is bought and sold for a fair market value more often than not. The buyer and seller can look at what comparable properties are sold for in the same area, then make offers to one another without being unduly influenced by things like personal relationships, business ties, and so on.
In theory, this ensures fair market value for the property being purchased or sold. Home value in arm’s length transactions can be determined by:
- Neighborhood comps as demonstrated above
- Property location
- Property size and usable space
- The age and condition of the property
- Whether there are any upgrades or updates to the property
- The interest rates
- Any other economic indicators
Lenders Prefer Arm’s Length Transaction
Lastly, it’s often much easier to finance an arm’s length transaction real estate deal because lenders prefer these transaction types. That’s because prices are generally not artificially high. Hence, lenders are at a lower risk of having to recoup an excessive amount of loan money if the mortgager or borrower cannot pay back their loan.
What is a Non-Arm’s Length Transaction?
Also called arm-in-arm transactions, non-arm’s length transactions are business deals where the buyers and sellers have “identities of interest.” In other words, the buyers and sellers have an existing relationship that can be personal or business-related.
Example of a Non-Arm’s Length Transaction
One easy example of a non-arm’s length transaction is a pair of parents selling their house to their oldest child. In such a transaction, it’s unlikely that they will sell the property for fair market value. Because of their pre-existing relationship, they will likely give their child a substantial discount.
Other examples of non-arm’s length transactions include:
- Sales between friends or business partners
- Sales between employers and his or her employees
- Sales between the trust and any beneficiaries
- Sales between a parent company and a subsidiary company
Effects of a Non-Arm’s Length Transaction
Non-arm’s length transactions can have significant tax implications for the buyer and seller. Because of this, real estate buyers or sellers need to consult tax professionals if their transaction is non-arm’s length, especially if the transaction could be considered a gift or capital gain.
However, it’s important to note that non-arm’s length transactions are not illegal or even necessarily bad ideas. That said, you need to clear some extra red tape before such real estate transactions go through to avoid being hit with a major tax liability.
Because of this, buyers and sellers must be very upfront and honest about their relationship and how it may affect the real estate deal.
Summary
As you can see, arm’s length transactions are some of the most common real estate deals in the world. The odds are that if you purchase a real estate property, you’re probably making an arm’s length transaction instead of a non-arm’s length deal unless you know the other party. That said, you need to be aware of the differences between both types of deals, so you don’t get tripped up on tax hurtles or have to pay extra fees because your purchase is considered a gift or a capital gain.
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