An arm’s length transaction is a deal wherein both buyer and seller are independent, unrelated, well-informed, have equal bargaining power, and are acting purely in their own self-interest to get the best price out of the deal. And because they are both on equal footing, an arm’s length transaction is one that meets fair market value.
How Is Fair Market Value Generally Determined in an Arm’s Length Transaction?
If a buyer and seller do not know each other, the buyer would want a price that’s as low as possible, while the seller would want a price that’s as high as possible. Each will use available information and their self-interest to determine the agreed on price. This is how fair market values are generally determined, and this is how most real estate transactions play out.
Why Do Lenders Prefer an Arm’s Length Transaction?
Lenders prefer an arm’s length transaction because the risk of fraud is lowered.
For example, imagine you’re the lender to a company formed to acquire their family’s home. However, after closing the loan you discover that the company’s managing member is the brother of the seller. It turns out the brothers conspired to transfer the residential property at an inflated price. Months later, the borrower defaults and the brothers disappear.
Now you’ve foreclosed on a residential property that’s worth less than the outstanding loan amount. Because both parties would have been acting purely in their own self interest, an arm’s length transaction would have greatly reduced the risk of a situation like this one.
Can Related People Still Do an Arm’s Length Transaction?
Yes, but both parties must show that the transaction was conducted no differently from how it would have been for someone they aren’t related to. This is done by hiring a professional appraiser, broker, or other disinterested third party who could confirm that the sale price is appropriate and reflects the true value of the property.
Because of the risk and cost of fraud committed by related parties, lenders will require the parties to be upfront and honest about the nature of their relationship. They will also be asked to provide several documents to verify that the transaction is indeed arm’s length. Usually, all of the following will be required:
- A copy of the contract between buyer and seller
- A comparative market analysis and independent appraisal of property
- An affidavit of arm’s length transaction disclosing the parties’ relationship and stating that the parties are acting in their own self-interest (without any hidden terms or special arrangements), are on equal footing, and that no collusion, influence or duress occurred.
- Independent verification that the sales price is close to fair market value, after comparing the contract terms with those of a similar transaction, but with unrelated parties
As long as you comply with these requirements, your transaction can be considered arm’s length.
What is the Problem With a Non-Arm’s Length Transaction?
A non-arm’s length transaction is risky for lenders, because knowing fair market value is critical to determine the terms to offer. If the buyer and seller are doing an arm-in-arm deal, there is also a chance that they may be hiding issues from the lender.
Since these all have a direct impact on bank financing or other municipal or local taxes, non-arm’s length transactions can lead to delays or cancellations of transactions, and even some undesirable tax consequences.
For example, if the sale of a house between father and son is taxable, tax authorities may force the seller to pay taxes on the gain he would have realized had he been selling to a neutral third party and disregard the actual price paid by the son.
Tax laws throughout the world are designed to treat the results of a transaction differently when parties are dealing at arm’s length and when they are not. A non-arm’s length transaction can have significant tax implications for both the buyer and seller.
Are Non-Arm’s Length Transactions Illegal?
No. While a non-arm’s length transaction may increase the risk of price manipulation, incur the scrutiny of third parties, disqualify it from participating in certain lending programs, or result in certain tax consequences, it’s not unlawful. However, if the parties colluded to manipulate the sales price to get a larger loan, it can be considered fraud.
The relationship is what qualifies a transaction as arm’s length or not. Third parties can decide how they’ll treat the transaction if it’s not arm’s length, but non-arm’s length alone is not illegal, nor is it necessarily a bad idea. It just comes with some extra red tape.
What Is an Arm-In-Arm (or Non-Arm’s Length) Transaction?
In contrast to an arm’s length transaction, an arm-in-arm (or non-arm’s length) transaction is a deal wherein two parties have some vested interest in helping each other. Here are some examples arm-in-arm transactions:
- Sales between friends or family members
- Sales between an employer and his or her employees
- Sales between parent companies and subsidiaries or affiliates
- Sales between principal owners and their family members
- Sales between management and their family members
- Sales between a company and related shareholders
- Sales between guardians and wards
- Sales between a trust and its beneficiaries
While there is no universal list of relationships that result in a non-arm’s length transaction, there are common denominators. Here are two red flags:
- One party has significant power over the other (to control or influence their actions)
- Both parties are close enough to work together in their joint interest to manipulate prices or conceal important facts about the transaction (collusion)
If any of these elements are present, there’s a greater chance that the sale price is not fair market value, because one party may give discounts or favorable terms to the other. In short, there’s a risk that they didn’t act independently of each other.
The Bottom Line
An arm’s length transaction is a deal between two independent, unrelated, well-informed parties who have equal bargaining power and are acting purely in their own self-interest. This is vital to lenders and tax authorities in particular because it lowers the risk of fraud. But even if both parties are related, the deal can still be classified as a bona fide arm’s length transaction if the proper requirements are complied with.