If you’re a real estate appraiser, noting whether a sale is an arm’s length transaction or a different type of sale is essential.
When you enter an arm’s length transaction, you can be sure that both parties are acting in their own self-interest, and they are not subject to pressure from the other party.
Additionally, third parties can rest assure that there’s no collusion between the buyer and seller.
To keep the transaction fair, both parties have equal access to information related to the deal.
Here’s what you need to know.
1. What does the expression “at arm’s length” mean?
This English idiom means “to remain distant or impartial.”
The expression is commonly used to refer to transactions in which two or more unrelated and unaffiliated parties agree to do business.
In this scenario, the two parties act independently and in their own self-interest.
In the next section, we’ll go into greater depths about what is typical of an arm’s length transaction.
2. What is an arm’s length transaction?
An arm’s length transaction is defined by the Legal Information Institute as a, “a transaction between unrelated parties who are acting in their own best interest.”
In this scenario, the market value is based on buyers and sellers being typically motivated and well-informed as well as each acting in their own best interest.
During an arm’s length transaction, the property is exposed on the market for a reasonable length of time.
Payment is made in cash or its equivalent.
The property is also unaffected by special or creative financing or sales concessions.
Arm’s length transactions should have parties that have equal bargaining power and symmetric information.
This allows the parties to agree upon fair market terms.
3. How does an arm’s length transaction work?
The price of an arm’s length transaction is the price that a willing buyer and willing seller would reasonably agree to if the buyer were trying to get the lowest price possible and the seller were trying to get the highest price possible.
The participants cannot be under any undue pressure and all parties must have the same information.
Here’s how it work:
A seller puts an object on the market
To initiate a transaction, a seller must put the item or property up for sale.
The potential “items” include a house, an investment property, a parcel of land, a car, or a piece of furniture.
A buyer signals their interest
To qualify for an arm’s length transaction, the buyer who approaches the seller must be an unrelated party.
They cannot be a friend, family member, or business associate.
Both parties negotiate
Without a previous relationship, both parties have equal bargaining power and the opportunity to negotiate in their own self-interests.
In this transaction, the seller is trying to sell for the highest price while the buyer is attempting to buy for the lowest price.
These prices are normally within a reasonable market price range.
The transaction resolves
Following negotiation, both parties can complete the transaction or abandon it for whatever reason (timing, pricing, etc.).
Neither party knows one another, and thus, they will be comfortable walking away from deals they don’t like.
Here are some steps you can take to reduce the impact an existing relationship can have on a deal.
Get an independent appraisal
When you’re buying or selling a property, it can be wise to get a real estate appraisal.
Similarly, for a business, get a business valuation.
The agreed-upon price should be close to the figure arrived at by the independent evaluator.
Get independent negotiators
When each party has an attorney, broker, or another type of professional and independent intermediary, the entire transaction is more likely to go smoothly.
This allows you to remain personally removed from the negotiating while your attorney or broker barters on your behalf.
Get it in writing
As with any legal transaction, get a contract in writing.
Do this in every single circumstance — no exceptions.
Make sure that every element of the deal is written out.
4. What is a non-arm’s length transaction?
A non-arm’s length transaction is one when parties may have a personal or close relationship.
This is sometimes called an arm-in-arm transaction because both parties are interested in the same outcome.
For example, sales between family members, personal friends, or a parent company and its subsidiaries would likely be a non-arm’s length transaction.
While arm-in-arm transactions aren’t necessarily illegal, they’re not always preferred by the IRS, and they can prevent you from obtaining financing from a lender.
In certain engagements, like a business sale, the seller must give a warranty that all aspects of the interaction have been conducted at arm’s length.
If it’s not, then the buyer could be entitled to damages.
It can also cause difficulties from a tax perspective.
You should note that negotiating an arm’s length transaction and the avoidance of a conflict of interest are similar concepts.
The conflict of interest occurs when the existing relationships of one entity (a person or company) make it difficult or impossible for them to fairly treat or represent the other entity(ies) that have different interests.
5. Why does it matter if a transaction is conducted at arm’s length?
Deciding to conduct a business deal at arm’s length ultimately has both legal and tax implications.
Several countries have tax laws that require holding companies or corporations to engage in business transactions with their subsidiaries at arm’s length.
This allows them to guarantee fair market conditions and ensure that taxes are allocated in those transactions to prohibit any potential conflicts that may occur.
6. What should you know about arm’s length transactions?
If you’ve never entered this type of transaction before, here are some quick takeaways.
The parties involved in arm’s length sales typically have no pre-existing relationship with one another
Arm’s length transactions usually ensure that properties are priced at their fair market value
Arm’s length transactions exclude those between family members or companies with related shareholders
7. Why are arm’s length transactions used in real estate deals?
You’ll often find arm’s length transactions used in real estate deals because the sale impacts those directly involved in the deal as well as other parties, like lenders.
When two strangers enter into an arm’s length transaction involving the sale and purchase of a house, the final agreed-upon price is likely close to fair market value.
The seller would want a price as high as possible while the buyer would want a price as low as possible.
Thus, assuming that both parties have equal bargaining power and information about the property, the agreed-upon price is not likely to differ from the actual fair market value of the property.
A real estate transaction at arm’s length directly affects the financing by a bank as well as municipal or local taxes.
The transaction can also affect how comparable properties are priced.
8. What special considerations do arm’s length transactions have?
When it comes to taxes, arm’s length transactions have quite a few tax considerations.
All over the world, tax considerations are designed to treat the results of a transaction differently when parties are arm’s length versus not arm’s length.
This is good for you to keep in mind whichever route you go.
Here’s an example of how a non-arm’s length transaction is taxed.
Say a father is selling his son his house.
Tax authorities deem this transaction taxable and may require the seller to pay taxes on the gain that he would have realized had he been selling it to a neutral third party.
That said, they would disregard the actual price paid by the son.
So, say the fair market value of the home was $450,000.
If the father accepted a price of $375,000, he would still have to pay taxes on $450,000.
Other transactions are treated differently.
For instance, international sales between non-arm’s length companies (such as two subsidiaries of the same parent company) must be made using arm’s length prices.
This practice is known as transfer pricing, which assures that each country collects the appropriate taxes on the transactions.
9. What are some examples?
Most business transactions in the United States will be considered arm’s length transactions.
These include:
Classified ads: Items advertised for sale in a classified ad are initiating an arm’s length transaction because they are advertising an item to people they don’t know and assume market value pricing.
Home sales: From new homes to second homes, home-buying transactions and real estate deals are normally made at arm’s length because the seller doesn’t know the buyer.
In the majority of cases, the two parties will never meet.
Instead, they’ll conduct the transaction through real estate agents or realtors, and determine the property’s value using the real estate market.
Online purchases: Online purchases are made at arm’s length because neither party meets or engages with the other during the transaction.
10. What are some examples of non-arm’s length transactions?
Here are two examples of non-arm’s length transactions:
In the first example, a mother wishes to sell her car to her daughter.
She might want to give her daughter a discount on the car (even though she could obtain a higher price if she sold it to another buyer at arm’s length).
Because the buyer and seller in this case are family members, they are not considered arm’s length.
In the second example, a founder of a publicly-traded company engages in nepotism by appointing one of their family members to an important position within the company.
While there were other more qualified candidates, they chose their family member, knowing this decision could hurt the company’s shareholders.
11. How is home value determined?
Arm’s length transactions ensure fair market value.
However, you may wonder how home value is determined at all.
Here are the primary factors that impact it.
Neighborhood comps
This factor considers the cost of recently sold comparable properties in the area.
By conducting a non-arm’s length transaction, buyers and sellers can impact the cost of other homes in the area.
In the interest of fairness, arm’s length transactions set the precedent for how much a property with similar characteristics is likely to be sold in a certain area or market.
Location
Home size and usable space
Age and condition
Upgrades and updates
The local market
Economic indicators
Interest rates
12. What are the advantages of an arm’s length transaction?
It’s preferred by lenders
Lenders prefer to underwrite loans for borrowers engaging in arm’s length transactions.
This is because they are less subject to mortgage fraud and more likely to follow standard market valuation.
In arm-to-arm transactions, lenders can adjust the terms of your down payment, closing costs, mortgage rates, or loan size (often using other factors like your LTV ratio or credit score).
It has fewer restrictions
There are numerous restrictions in place for non-arm’s length transactions.
Banks, mortgage lenders, tax laws, the IRS, and other government agencies put these restrictions in place to prevent fraud in certain situations.
Some of these restrictions and implications can include supplementary analyses of the contract, affidavits, capital gains taxes, and independent appraisers.
If you opt for an arm’s length transaction, you don’t have to worry about any additional requirements, which is often preferable for buyers, sellers, and lenders.
It avoids social politics
When you engage in an arm’s length transaction, both buyers and sellers are free to negotiate with their best interests in mind.
Non-arm’s length transactions, on the other hand, often prompt negotiators to feel uncomfortable.
They may worry about the other party’s feelings or feel concerned about the lasting impacts of the transaction on their business or personal relationship.
13. What are the disadvantages?
It can take longer
Sellers often must wait longer in an arm’s length transaction to find an interested and willing buyer.
Additionally, both parties will often spend some time negotiating, which can further lengthen the process.
On the other hand, familiar parties will often initiate and negotiate much more quickly because of their existing relationship.
It offers less context between parties
This type of transaction is negotiated between strangers, which means neither has access to information about the other party unless they reveal it.
Often, this means that parties will purposely conceal information from one another to attempt to get the best deal they can.
In arm-to-arm transactions, both parties have information about the other because of their existing relationship.
It lacks deep discounts
Because a sale made at arm’s length is often close to fair market value, they’re less likely to offer deep discounts.
In arm-to-arm transactions, parties often consider the other’s emotions, and one may give the other a better deal to preserve or strengthen the relationship.
Final Thoughts
You’ve likely engaged in numerous arm’s length transactions in your life.
Whether you’ve purchased a home from an unknown seller or bought something off the internet, these are transactions conducted at arm’s length.
This type of transaction has numerous benefits as well as some drawbacks.
Their primary goal is to keep the process impartial.
Additional Resources
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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.
Prior to starting Gokce Capital, Erika received a Bachelor of Architecture from the University of Southern California and a graduate degree in Urban Policy from Columbia University. She worked as both an architectural designer and engineer in New York before joining the New York City Department of Housing Preservation and Development.
Erika currently lives in the New York Metropolitan area with her spouse, daughter and cat. She is originally from Chicago and still considers herself a midwesterner at heart.
Erika also loves to read, write and travel (fun fact, she has visited all 50 states and more than 30 countries!). Her new book, Land Investing Mistakes: 11 True Stories You Need To Know Before Buying Land, is now available on Amazon.