Let’s imagine two people standing apart from each other, at least arm’s length apart. It might be safe to imagine they don’t know each other very well. Now, let’s imagine a second couple. They are standing close to each other, maybe even arm in arm. It might be safe to assume they know each other well – very well.
In real estate, if couple no. 2 were friends, family members or business partners and one of them was buying a house from the other, that would be a non-arm’s length transaction. And that first couple that stood at least an arm’s length away from each other? If one was buying a house from the other, that would be an arm’s length transaction.
Non-arm’s length transactions and arm’s length transactions are real estate terms used to describe the relationship between the buyer and seller – and each comes with stipulations.
Non-arm’s length transactions can benefit both sellers and buyers, but they also come with increased scrutiny, restrictions and requirements to prevent either party from taking advantage of the other or avoiding obligations like property taxes.
What Is a Non-Arm’s Length Transaction?
In a non-arm’s length transaction, there is a preexisting relationship between the buyer and the seller. In an arm’s length transaction, there is no preexisting relationship between the buyer and the seller.
If your parents sell you their old beater car, that’s a non-arm’s length transaction. But, if you buy your shiny, new Benz from the local car dealership, no matter how friendly the dealer was, that’s an arm’s length transaction.
In a non-arm’s length transaction, the buyer and seller can be relatives, friends, married or soon-to-be married. There are even preexisting relationships between organizations or businesses. On the other hand, people or businesses involved in arm’s length transactions are unrelated and behave independently.
Lenders, such as banks, credit unions or online lenders, must follow stricter guidelines when underwriting loans for arm’s length transactions because of the heightened risk of fraud associated with these real estate transactions.
When buyers and sellers act independently and in their best interests, transactions are less susceptible to mortgage or tax fraud, and the home sale price is more likely to reflect fair market value. Lenders may impose stricter guidelines or costlier terms on non-arm’s length transactions than they would with arm’s length transactions.
What Should I Know Before Pursuing a Non-Arm’s Length Transaction?
Selling your home to a family member, or buying one from a friend, can mutually benefit the both of you – but it ain’t always easy. There are important considerations to keep in mind, including the potential stress this kind of transaction could put on the relationship.
To ensure buyers and sellers are acting in their own self-interest and are protected from any potential influence from the other party, lenders apply added restrictions to safeguard all parties involved, including the lender.
Let’s take a look at other important considerations you’ll need to keep in mind.
Restrictions are stricter for non-arm’s length transactions
You’ll have to jump through a few more hoops for a non-arm’s length transaction. Let’s say you want to buy a house in a non-arm’s length transaction using a Federal Housing Administration (FHA) loan.
In an arm’s length transaction, you can pay 3.5% down on an FHA loan. According to the FHA’s rules on identity-of-interest transactions for a sale between parties with family or business relationships, non-arm’s length transactions are restricted to an 85% loan-to-value (LTV) ratio.
So you’ll pay at least 15% of the home’s purchase price for a down payment unless you qualify under one of these exceptions:
- The home will be your primary residence.
- You’re purchasing the primary residence of a relative, fiancé(e) or domestic partner.
- You’re purchasing a property you’ve been renting at least 6 months before the transaction.
- You’re the employee of a property developer, and you’re purchasing one of the developer’s homes as your primary residence.
The IRS takes serious measures to ensure that home sales are made at fair market value. Non-arm’s length transactions are closely scrutinized to identify when sales are made above fair market value to capitalize on gains or below fair market value to avoid taxes, potentially resulting in double taxation.
You may be subject to capital gains taxes if you buy a house for cheap then sell it for a lot more within 2 – 5 years.
Gift of equity
A gift of equity refers to the difference between a home’s fair market value and its purchase price. This happens when a friend or family member sells you a home close to or below its fair market value.
For example, if your dad sells you a home for $400,000 when its fair market value is $650,000, the gift of equity is $250,000. (Sidebar: Buyers may be allowed to put a gift of equity toward their down payment.)
If you buy a home in a non-arm’s length transaction, you may face extra taxes for a gift of equity.
As of 2022, an individual may receive a gift of up to $16,000 before the gift must be reported to the IRS. The seller usually pays the gift tax, but arrangements can be made to make the buyer responsible for payment.
These are a few requirements associated with gifts of equity:
- A gift letter signed by the seller must be submitted to the IRS. It must state the property’s address, the amount in equity, the relationship between buyer and seller and stipulate that the gift of equity doesn’t need to be repaid.
- There must be a completed appraisal on the home that determines its fair market value.
Gifts of equity most commonly happen between parents and their adult children, but nearly anyone can provide a gift of equity, assuming they follow IRS guidelines and rules.
Cheaper closing costs
While non-arm’s length transactions come with more restrictions and tax implications, some benefits make it worth the extra effort and potential expenses. For example, when you’re buying a home from a family member, you won’t need a real estate agent, which means neither you nor the seller will need to pay commission fees.
Commission fees often cost up to 6% of a home’s sale price and are often paid by the seller.
Non-arm’s length transactions can potentially avoid hiccups when buyer and seller have a close and trusting relationship. When there’s a good rapport, you can be open and honest about the home’s condition, potentially avoiding home inspection costs.
The rapport between the buyer and seller may influence both of them to be more flexible about specific deal terms, such as closing and moving dates.
How Do I Buy a House in a Non-Arm’s Length Transaction?
Buying a house in a non-arm’s length transaction is similar to buying a house in an arm’s length transaction.
Check out the steps you’ll need to follow in a non-arm’s length transaction.
Getting preapproved is a fast way to find out how much you’re approved to borrow, and it can streamline the buying process. Mortgage preapproval gives lenders greater insight into your financial situation and helps them determine if you would qualify for a mortgage.
Using your credit score, debt-to-income (DTI) ratio, income and other relevant financial information, lenders can determine the loan amount, interest rate and mortgage terms you’re eligible for. When you’re preapproved, you know what you can afford and what size down payment you’ll need to make.
For both buyers and sellers, the fair market value of a home plays a big part in a home sale. To determine the appropriate purchase price, you’ll both need an appraiser or real estate agent to provide the estimated fair market value.
- Real estate agents can use their market knowledge, looking at the sale prices of similar homes in the neighborhood or a comparable area.
- A professional home appraiser will complete a top-to-bottom examination of the home, taking obvious home defects into account but mainly focusing on the overall value of the property.
Once you’ve mutually established the home’s fair market value, you and the seller can set the purchase price. Remember that closing costs, down payments or gifts of equity, should be accounted for within the purchase price. If you’re unsure about what should be included in the purchase price, check with a tax professional.
A purchase agreement, also known as a sales contract or a sales and purchase agreement, is a legally binding contract between a buyer and a seller in a real estate transaction. The purchase agreement outlines and defines every aspect of the transaction, such as terms, contingencies or other important information. A typical purchase agreement includes:
- Buyer and seller information
- Property details
- Purchase price
- Items or fixtures included in the sale
- Closing dates
- Contingencies (like repairs or inspections)
Even if you have a good relationship with the seller, running a title search is a necessary security measure before committing to buy a home. A title search examines public records and verifies that there are no other legal owners of the property.
During the underwriting phase, the lender focuses on the buyer’s credit history and their creditworthiness. Lenders use this information to confirm that you’re a reliable borrower who’ll be able to make your monthly mortgage payments.
Lenders will look very closely into the buyer and seller during this step to ensure they’re each acting in their self-interest and that the transaction meets the lender’s standards.
You’ve made it to closing, and all the hardest parts are over. Once those shiny keys are in your hand, it’s time to celebrate your achievement.
While you’re enjoying your milestone, it’s important to remember that the IRS isn’t necessarily finished with the transaction. The IRS may choose to audit the transaction to confirm it was completed in full compliance and without any errors.
Buying a Friend’s House? Avoid Mortgage Fraud
Parents, friends or other loved ones sometimes sell their homes at generously low prices to give someone they love the opportunity to keep a home in familiar hands. As a seller, you can avoid paying a real estate agent commission, and as a buyer, you can avoid dealing with a competitive real estate market and enjoy the financial perks of built-in equity.
But don’t let these benefits blind you. Pay close attention to all of the requirements and rules so you can fully enjoy your new home.
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