An arm's length transaction is another way of saying a normal, legitimate business transaction -- whether for a primary home or investment property -- one where the parties don't know each other, and one where they act with their own self-interest in mind: The seller tries to get top dollar for real property and the buyer tries to get the best deal.
Once that real estate transaction happens, you typically arrive at fair market value, which is the reason an arm's length transaction can provide an accurate comp for neighboring properties.
A non-arm's length transaction example
Here's an example of how a non-arm's length transaction -- a transaction where the parties know each other -- can skew a deal:
A neighbor of mine once sold a home to a colleague for significantly more than what the market was fetching at the time. Some of the other neighbors were excited about this deal, thinking it meant their property value increased from that one sale alone. If this were an arm's length transaction, they would have had a point. But because this particular sale was between colleagues -- meaning it was not an arm's length transaction -- the price reflected something other than fair market value: It represented a deal struck between colleagues and therefore can't be used for comparison purposes.
Why a non-arm's length transaction can skew comps
When the two parties in a real estate deal know each other in some way, one of two things can occur:
- One party can manipulate, coerce, or leverage the other party.
- The two parties can collude to manipulate the sales price.
The outcome of both scenarios would not necessarily reflect fair market value of the property, as the price would be based on other factors.
Advantages of arm's length transactions
Several advantages surround an arm's length transaction deal.
Provides a fair comparison
One of the best ways to value your property is to look at what comparable properties recently sold for. You'll usually need to make adjustments up or down depending on how much better (or inferior) your home is to the home you're comparing it to. But you'll be in the ballpark at least.
Lenders prefer arm's length transactions
It's easier to finance an arm's length transaction deal. If the price is artificially high, as what could happen with a non-arm's length transaction, and the lender needs to foreclose, that mortgage lender might not be able to recoup the loan money if the foreclosure property sold for an inflated price.
Taxes are straightforward
It's easy to estimate taxes on arm's length transaction deals because they usually represent the property's fair market value. In deals struck that are above or below fair market value, taxes associated with the deal will usually be affected as well.
Types of transactions that are not arm's length
Transactions in which the parties know each other or have an existing relationship are non-arm's length transactions, sometimes called "arm-in-arm transactions." Arm-in arm- transactions can be between friends, family members, business associates, and companies to shareholders.
How to conduct a non-arm's length transaction
There's nothing wrong or illegal about conducting a non-arm's length transaction. If you wish to buy or sell a property to someone you have a relationship with, you can. It's advisable to hire an attorney and a tax professional to oversee the deal.
These professionals can ensure you're doing everything by the book. Even if your intentions are good, you could be doing something wrong or missing a detail. An attorney and tax professional can help ensure everything is being done correctly.
Certain fraudulent schemes are associated with arm-in-arm transactions, because of the nature of the association between the two parties, and this makes lenders and tax authorities closely scrutinize these deals.
For example, mortgage fraud occurs if two related parties collude to raise the sales price in order to defraud a lender into lending more money. Or two parties might plot to lower the purchase price to get a break on property taxes. An appraiser can determine whether this sort of fraud might be happening after conducting an appraisal.
The Millionacres bottom line
In its most basic iteration, an arm's length transaction is one in which fair market value for a property is achieved. When it comes down to basics, it doesn't matter who the two parties involved are; what really matters is the price.