You may have heard the term “Arms Length Transaction”. This legal term describes the relationship between a buyer and a seller in a real estate transaction. The vast majority of real estate transactions are arms length transactions. So, how does this differ from a “non-arms length transaction” in real estate?
What is an Arms Length Transaction?
An arms length transaction in real estate refers to a transaction where the buyer and seller are unrelated and have no pre-existing relationship or connection with each other. In such a transaction, both parties act in their own self-interest, without any external influence or pressure, and negotiate the terms of the sale or purchase without any undue advantage to either party.
The term “arms-length” is often used to refer to transactions that are fair, equitable, and conducted on market terms. In other words, the price and other terms of the transaction should be similar to what would be agreed upon by unrelated parties in a similar transaction, without any influence or coercion.
Arms-length transactions are important in real estate because they help ensure that the property is sold or purchased at fair market value, without any undue influence or manipulation. This is particularly important in situations where the parties have a pre-existing relationship, such as between family members or business partners, as there may be a higher risk of unfairness or conflict of interest.
What is a Non-Arms Length Transaction?
A non-arms length transaction is one in which the buyer and seller have a pre-existing relationship or connection with each other. Many times, this this type of transaction may not be conducted on market terms.
In such a transaction, the parties may not act in their own self-interest, and there may be external influence or pressure that affects the terms of the transaction. This can result in a sale or purchase price that is not reflective of the fair market value of the property.
Examples of non-arms length transactions: sales between family members, sales between business partners, or sales between a corporation and a related party such as a director or officer of the corporation.
More Work for Appraisers and Lenders
Non-arms length transactions can create challenges for real estate appraisers, lenders, and other stakeholders. It can be difficult to determine the fair market value of the property when there may be other factors influencing the transaction.
When handling a non-arms length transaction, an appraiser may need to make additional considerations in their valuation process to ensure that the transaction reflects fair market value.
Here’s an example of how an appraiser may approach a non-arms length transaction:
Let’s say that a homeowner wants to sell their property to their son for a price that is significantly lower than the market value. The appraiser would first need to determine whether the transaction qualifies as a non-arms length transaction. They would review the sales contract and ask questions to determine the relationship between the buyer and seller.
Assuming that it is a non-arms length transaction, the appraiser would need to make adjustments to their valuation to account for the non-market terms of the transaction. They may need to consider additional comparable sales that are arms-length and adjust for any differences in condition or location. The appraiser may also consider any relevant market conditions, such as supply and demand for similar properties, that could impact the value.
The appraiser would also need to document their findings and rationale for any adjustments made to the valuation. This would help to ensure that the appraisal is supportable and can withstand scrutiny by regulators or other stakeholders.
Overall, the key challenge for an appraiser in a non-arms length transaction is to ensure that the valuation reflects fair market value, despite the relationship between the parties involved in the transaction. This may require additional analysis, documentation, and communication with the buyer, seller, and any other stakeholders involved in the transaction.
How Do Tax Authorities Handle Non Arms Length Transactions?
In some cases, non-arms length transactions may be scrutinized more closely by regulators or tax authorities to ensure that the transaction was conducted on market terms and that any tax implications are properly accounted for.
When a taxing authority, such as the Internal Revenue Service (IRS) in the United States, encounters a non-arms length transaction, they may take additional steps to ensure that the transaction is properly valued for tax purposes.
Here’s an example of how a taxing authority may handle a non-arms length transaction:
Suppose a homeowner sells a property to their sibling for a price significantly below market value. In this case, the IRS may view the transaction as a non-arms length transaction and seek to determine whether the sale price accurately reflects the fair market value of the property. This is because non-arms length transactions can create opportunities for parties to manipulate prices for tax purposes.
To determine the fair market value of the property, the IRS may request an appraisal or other documentation to support the valuation. They may also review any relevant sales data or market conditions to ensure that the sale price is in line with similar transactions in the area.
If the IRS determines that the sale price does not reflect fair market value, they may adjust the value of the property for tax purposes. This could result in additional tax liabilities for the parties involved in the transaction, as well as penalties and interest.
Overall, the key concern for a taxing authority in a non-arms length transaction is to ensure that the transaction is valued fairly for tax purposes. This may require additional analysis and documentation to determine the fair market value of the property, as well as communication with the parties involved in the transaction to verify any information provided.
Arms-length transactions are important in real estate because they help ensure that the property is sold or purchased at fair market value, without any undue influence or manipulation. Non-arms length transactions, on the other hand, require additional considerations by appraisers, lenders, and taxing authorities to ensure that the transaction reflects fair market value, and the parties involved are not taking advantage of the relationship for tax or other purposes.
Overall, it’s important for all parties involved in a real estate transaction to understand the type of transaction and to take the necessary steps to ensure that it’s conducted fairly and transparently. This includes obtaining appraisals, documenting the transaction, and communicating openly with all stakeholders.