What is an arm’s length transaction?
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UPDATED: Nov 29, 2012
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An arm’s length transaction refers to a sale where a buyer and seller know each other but act independently of one another without taking into account their relationship. The point of arm’s length transactions is to prove that both the buyer and seller are operating in their own self interest without being pressured by one another.
In real estate, arm’s length transactions are necessary to establish the fair market value of a property. A buyer and a seller must use an arm’s length transaction when purchasing a home since, if both parties know each other, the agreed-upon price will likely differ from the true market value. In essence, two parties with a familial or friendly relationship will likely agree to lower the price of a given property due to their relationship. This can have major tax or legal ramifications in the future. In fact, mortgage loan fraud lawsuits often appear in the news when an arm’s length transaction was not conducted. In order to operate safely and by-the-book, an arm’s length transaction must be performed.
An example may better illustrate how this works.
A seller puts his home up for sale, and a buyer submits an offer. The seller has no knowledge of the person who‘s interested in purchasing the home. The seller and buyer have never met and are only aware of each other through a realtor. The buyer’s offer is approved, so he or she obtains a mortgage loan. After borrowing a mortgage loan, the home gets purchased at market value because both parties pushed for a price amount that was in their best interests. Negotiations prompted them to compromise and haggle until their price points met in the middle, so to speak. The buyer, who ultimately purchased the home, moved into the property after completing all the necessary paperwork without having met the home’s original owner.
A different situation can show what happens in non-arm’s length transactions:
Imagine a father is a successful investor who owns three homes. His son has saved enough money to afford the down payment on a property. Hoping to assist his son, the father says he will simply sell his son one of his investment homes. The son, obviously wanting to save money, decides to proceed with the plan. The price the father gives him for the home is far below market value since the father wishes to help his son save money on such a sizable purchase. As a result, the son only needs a mortgage loan worth a fraction of the property’s real value. He takes out the mortgage loan and purchases the home. In the months after the purchase, his monthly mortgage payments are lower than they should be since the amount borrowed is low for the type of home he purchased. This clearly was a home purchase that was far from market value and not completed at “arm’s length.” As a result, the father and son have exposed themselves to a lawsuit from the mortgage loan lender for not conducting an arm’s length transaction.