Non-Arm’s Length Transaction: What Is It and How Does It Work?
JA
Summary:
When the buyer and seller of a property don’t have a close relationship with each other, the transaction is called an arm’s length transaction. However, when there’s an existing relationship between the seller and the buyer, the transaction is a non-arm’s length transaction. Lenders are typically more suspicious of non-arm’s length transactions since there’s a higher risk for fraud and manipulation.
When you’re on the hunt for a new home, one of the first things that may come to mind is using resources like Zillow to look for suitable properties. And in most cases, the property seller is a stranger whom you’ve never met. However, another popular option when buying a home or investing in real estate is doing so through a non-arm’s length transaction (NAL) — a deal with someone you know, such as a family member or close friend.
Though NALs are legal, mortgage lenders will scrutinize these types of transactions since they often involve conflicts of interest and potential for manipulation. In this article, we’ll explore what exactly a non-arm’s length transaction is and how it works.
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What is a non-arm’s length transaction?
In real estate, a non-arm’s length transaction refers to a deal where the parties involved have a relationship with each other — such as marriage, friendship, business partnership, employment, or blood relation.
Because of this pre-existing relationship, rather than an objective sale between the two parties, non-arm’s length transactions may be tilted in favor of one party. The nature of this type of transaction may often result in issues such as unfairness or manipulation.
Tax implications of a non-arm’s length sale
One of the most important things to keep in mind with an NAL is the resulting tax implications of the sale. Let’s say your parents are offering to sell you their property for far below the fair market value price.
In this case, you would receive a gift of equity. However, the IRS has limits on how large such a gift can be without taxes. In 2022, an individual could offer an equity gift of $16,000 (or $32,000 if married), which is likely far below a house’s value. This means the seller (your parents) would be responsible for paying taxes on whatever income they receive above that number.
IMPORTANT! In addition to the seller’s tax responsibility, if you decide to sell the property within a few years of purchasing it, you may have to pay capital gains taxes. Make sure to check with a tax professional or accountant so you know what your tax liability may be before completing a non-arm’s length transaction.
Arm’s length vs. non-arm’s length transactions
Arm’s length transactions are the exact opposite of non-arm’s length transactions. In these deals, the buyer and the seller don’t know each other, so they can negotiate objectively without letting the other person influence their decision.
For example, if you’re the seller in an arm’s length real estate transaction, you’ll try to sell your property to the highest bidder, while the buyer will try to get the best deal. Eventually, you’ll meet in the middle and sell the home at a fair market value price. Because you don’t know the seller (and vice versa), you can act in your own self-interest without anyone affecting your decision-making process.
On the other hand, non-arm’s length transactions are not as straightforward. An individual negotiating with a family member may be more likely to accept their terms even if they don’t offer the most favorable outcome. In some cases, business partners can even work together through a non-arm’s length transaction to commit fraud.
Are non-arm’s length transactions better than arm’s length transactions?
While one isn’t necessarily “better” than the other universally, NALs are far more scrutinized than arm’s length transactions. And this applies to more than just mortgage lenders who offer conventional loans.
Because of the potential for fraud, lenders offering government-backed mortgages have different restrictions for NAL transactions. For instance, to get an FHA loan for an arm’s length transaction, a borrower must pay a minimum down payment of 3.5% of the property’s purchase price. For a non-arm’s length transaction, this down payment requirement jumps to 15%.
That being said, provided you have enough saved up for a 15% down payment, an FHA loan can still be helpful for first-time homebuyers. To get a better idea of the rates you may qualify for, take a look at some of the mortgage lenders below, all of whom offer FHA loans.
How could mortgage fraud happen in a non-arm’s length transaction?
According to Matt Teifke, real estate investor and owner of Teifke Real Estate, “some of the most common mortgage frauds that happen in non-arm’s length transactions include providing false information, foreclosure rescue scams, and appraisal fraud.”
- Exaggerating false information. In a non-arm’s length transaction, a borrower may be tempted to provide false information on the loan application to obtain a mortgage with better terms. This could include exaggerating income, providing false employment information, or other forms of misrepresentation.
- Foreclosure rescue scams. This type of fraud typically involves a seller that promises to help the borrower avoid foreclosure by offering to purchase their property for less than its market value. The seller then rents the property back to the borrower with a promise of eventually repurchasing it. In reality, the seller never intends to buy the property back and simply pockets the money from the sale.
- Appraisal fraud. This type of fraud typically involves the borrower or seller inflating the value of a home on the appraisal report to qualify for a larger loan from a mortgage lender. This could include providing false information about the property or the area in which it is located or bribing an appraiser to give a false report.
Remember, the activities mentioned above are illegal and could result in severe consequences. If a mortgage lender suspects fraudulent activities in a non-arm’s length transaction, they could deny the loan or even pursue legal action.
Should you buy a house at non-arm’s length?
It depends. It could be beneficial to purchase a house from someone you know, but you must perform due diligence to ensure that you’re getting a fair deal. Here are some questions to ask yourself before signing on the dotted line:
- Does the other party have the financial resources to complete the transaction? Are they fully disclosing all relevant information about the property and their financial situation?
- How will the transaction affect my relationship with the other party, and am I prepared for the consequences if things do not go as planned?
- Am I paying fair market value for the property? Or, is there a probability that the price is inflated or manipulated?
Pro Tip
If there’s doubt that a non-arm’s length transaction is not in your best interest, seek professional advice from a certified mortgage professional, real estate agent, or attorney specializing in these transactions.
FAQs
Does Fannie Mae allow non-arm’s length transactions?
The Federal National Mortgage Association, also known as Fannie Mae, offers affordable financing to moderate- to low-income borrowers. Instead of originating the loans, they purchase them through the secondary mortgage market.
According to Fannie Mae’s selling guide, they will only purchase “mortgage loans secured by a principal residence” if it’s for a newly constructed property and the borrower has a relationship with the seller. However, if it’s for an existing property, Fannie Mae allows non-arm’s length transactions “unless specifically forbidden for the particular scenario, such as delayed financing.”
Can an appraiser use a non-arm’s length transaction?
Yes, they can. That said, appraisers typically view these types of transactions as riskier since the seller and buyer know each other and could potentially influence each other’s decisions. Though non-arm’s length transactions are legal, they’ll likely face greater scrutiny since there’s a higher chance of fraud or manipulation.
What does it mean to keep at arm’s length?
To keep at arm’s length means to keep at a distance and avoid developing a close relationship. As their names suggest, an arm’s length transaction means deals where the two parties are unrelated or unaffiliated, and a non-arm’s length transaction means the two parties have a certain degree of closeness or affiliation.
Key Takeaways
- Non-arm’s length transactions are business deals between two parties with a preexisting relationship, such as family or business partners.
- Non-arm’s length real estate transactions can be tilted in favor of one party and may often result in unfairness or manipulation.
- Opposite to NAL is an arm’s length transaction involving buyers and sellers who don’t know each other. This allows both the buyer and the seller to negotiate objectively without influence from the other person.
- Mortgage fraud is a common issue in NAL transactions, so lenders tend to be vigilant when reviewing such deals.
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