Buying and selling real estate is expensive. In order to ensure that it’s conducted in a fair and practical way, there are certain regulations you must follow. One of them is the arm’s length sale. As the name suggests, you must have a ‘spaced out’ relationship with the seller. In other words, you can’t buy the home from your mom or uncle.
Why are Non-Arm’s Length Transactions Bad?
You may wonder what the harm is in conducting a non-arm’s length transaction. After all, you are buying/selling a home – everyone profits, right? When you buy a home from a complete stranger, this is typically the case. The transaction is fair on both ends of the deal. However, when you buy from someone that is close to you, there could be other complications that occur.
Take this situation as an example:
You are selling your house for $400,000. You’ve had buyers come through the home willing to pay that much. In fact, you receive an offer from a potential buyer for the full listing price of $400,000. But then you talk to your sister who is devastated that you are selling your home. She doesn’t want you to get rid of it, so she offers to buy it for $300,000 because that’s all that she can afford.
The transaction with the stranger would be an arm’s length transaction. Both parties are operating on their own self-interest. You list the home for the market value and the buyer is willing to pay that amount because he/she knows that’s the going value.
The transaction with your sister would be a non-arm’s length transaction. You aren’t acting in your best interest because you aren’t getting what you want for the home. You listed it for $400,000 but are willing to give into the lower price because it’s your sister – how could you not? You feel pressured into selling to her or causing huge family issues.
Why would this be bad? Well for starters, you walk away with an emptier pocket. But, even worse, you’ve just lowered the average market value in the area even though it’s not a true indication of the home’s value. Anyone that sells a home in the area within the next six months may get less for their home because of the sales price you accepted to sell to your sister. It has a domino effect that hurts everyone in the area, not just you.
What are Common Examples of Non-Arm’s Length Transactions?
Any sale that falls within the following categories is considered non-arm’s length:
- Selling your home to a friend
- Selling your home to a family member
- Selling your home to an employer or employee
- Selling your home to one of the beneficiaries of your trust
Handling a Non-Arm’s Length Transaction
This isn’t to say that non-arm’s length transactions can’t occur. They can, but with more red tape. You must disclose your relationship from the start. Don’t try to hide the fact that you are related or work for one another, for example.
In addition, you’ll have to sign an affidavit stating that there aren’t any special terms going on with the sale. For example, you aren’t giving a kickback to the buyer or have special arrangements that allow you to move back into the home after you sell it.
Finally, the lender may require extra evaluation of the home’s value. It’s not unusual for lenders to request two independent appraisals on a property involved in a non-arm’s length transaction. This way the lender knows beyond a reasonable doubt that the selling price is a fair indication of the home’s value.
The key is to be honest from the start. It’s not that you can’t buy a home from a relative; it’s just a little trickier. Talk with your lender about the precautions you must take in order for it to be a sale that is in the best interest of everyone involved.