What Is an Arm’s Length Transaction? Its Importance, With Examples

Lenders that offer government-backed mortgages like FHA loans have different guidelines they have to follow for non-arm’s length transactions. For example, for an arm’s length transaction, the down payment for an FHA loan is 3.5% of the purchase price. For a non-arm’s length transaction, however, the down payment must be a minimum of 15%.

The concept is also used in establishing transfer prices between subsidiaries, so that prices are not unusually high or low (which can impact a subsidiary’s taxable income). The question of whether or not a transaction is arm’s length matters because it can have legal and tax implications. If the sale of a house between father and son is taxable, tax authorities may require the seller to pay taxes on the gain he would have realized had he been selling to a neutral third party. A non-arm’s length transaction is not illegal, but will face greater scrutiny since there is greater chance of fraud.

What is an arm’s length transaction?

For clarity’s sake, let’s say the father’s name is John and the son’s name is Henry. An existing relationship tends to influence the terms of a non-arm’s length transaction. For instance, it’s unlikely that a transaction involving a father and his son would yield the same result as a deal between strangers because the father may choose to give his son a discount.

One of the benefits of a non-arm’s length transaction is lower closing costs. Family members do not have to use a real estate agent and can save up to 6% in commissions. The impact of the report, indicating that Aphria’s acquisition of assets in Latin America was not at arm’s length, caused the stock of Aphria to plunge. Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom. The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters.

In an arm’s length transaction, both the buyer and seller are trying to get the best price possible. The seller wants to sell at the highest price and the buyer wants to buy at the lowest price. As both parties negotiate, the transaction price will typically be close to the fair market value of the property. About your inquiry and other home-related matters, but not as a condition of any purchase. MoreYou also agree to our Terms of Use, and to our Privacy Policy regarding the information relating to you.

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As long as you comply with their stipulations, your non-arm’s length transaction should go smoothly. On a personal level, a non-arm’s length transaction can have significant tax implications for both the buyer and seller. Be sure to consult a tax professional, because the sale will be taxed differently depending on whether the transaction is considered a gift, like-kind exchange, or capital gain.

Defining what doesn’t count as “arm’s length” is a bit trickier, because it’s hard to identify whether or not someone is acting in self-interest or in the interest of someone close to them. That said, generally, any relationship where one party is felt to have significant power over the other or where the two are close enough to work together in their joint interest is seen as a red flag. If Colin sells the house to the stranger, it would be an arm’s length transaction because both parties are independent and acting in their own self-interest. Colin is looking to sell his house as he is moving to another country. His older brother, John, is coincidentally looking for a house to purchase. Before accepting offers, Colin gets an appraisal for the house and determines that the fair market value of the house is $1,000,000.

To avoid potential issues, post your questions to UpCounsel’s marketplace. Every buyer and seller wants to get the best price possible for their financial transactions. One of the best ways to do so is to conduct an arm’s length transaction. Being at arm’s length means there are no personal factors that influence the price and the decision to either accept or reject an offer.

The term LTV gets used in risk assessment to express the ratio of the loan to the value of the asset being purchased. In some cases, the 85 percent LTV can be waived if the buyer has lived at the property for six months or more before the purchase. Other exceptions include one of a home builder’s employee buying a house. “Arm’s length” refers to a legal transaction in which buyers and sellers of products or services have no relationship to one another either by blood, marriage, or business dealings. Without previous ties, an arm’s length transaction makes sure neither person feels pressured by the other or acts in connection with one another.

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Although John’s welfare is maximized due to him being able to purchase the house at his offer price, Colin is not acting in his own self-interest to attain the best deal. First and foremost, both the seller and the buyer will be expected to be upfront and honest about the nature of their relationship. Usually, an affidavit is drawn up to document these details in writing. Similarly, conglomerates and holding companies can potentially run into legal and regulatory challenges if the companies within their organization do not transact with one another at arm’s length. Ultimately, Arm’s Length Transactions are intended to encourage fair and reasonable business practices and to protect the public at large.

Parents who sell their house valued at $250,000 for the bargain price of $150,000 to their child is one example. The transaction won’t likely produce the same result if it occurred between two people with no relationships between them. An arm’s length transaction serves as a basis for figuring out fair market value (FMV). This value is the estimated price of a property based on what a buyer would pay based on values in the current real estate market.

• There is also a higher probability that the transaction price is not fair market value.
• In addition, the IRS can impose penalties if a non-arm’s transaction is not conducted properly.
• There are some exceptions for an FHA loan, such as purchasing property from a fiancé or domestic partner, and if you are purchasing property that you have rented for the last six months.
• If a seller wants a relative to buy a home below market price, the transaction could be considered a gift instead of an arm’s length transaction.

In the interest of fairness, both parties usually have equal access to information related to the deal. Lenders are more likely to finance arm’s length transactions than non-arm’s length transactions. Closely related people in real estate transactions can manipulate the price or engage in illegal activity. Lenders, assessors, and other parties have to scrutinize these types of loans more.

Those who execute non-arm’s length transactions may not get the best price, which can also affect the overall market and lending decisions. As noted above, one of the main benefits of arm’s length transactions is that the transaction is fair and equitable. When the buyer and seller have no previous relationship, the terms of the deal—notably, the sale price—accurately reflect market conditions rather than being influenced by other factors. Family members and companies with related shareholders generally don’t engage in arm’s length sales. This type of transaction, which is also known as an arm-in-arm transaction, refers to a business deal in which buyers and sellers have an identity of interest. Put simply, buyers and sellers have an existing relationship that is either business-related or personal.

The Importance of an Arm’s Length Transaction: Aphria Inc.

The idea of an arm’s length transaction, also known as an arm-in-arm transaction, came about in the real estate market as a way of handling tax authorities. Generally, family members and businesses with related shareholders are not acting at arm’s length, which can cause ethical problems. Such ethical issues include a company’s supervisor who forces an employee, under the threat of termination, to buy real estate using the boss’s name.

Tax laws throughout the world are designed to treat the results of a transaction differently when parties are dealing at arm’s length and when they are not. We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.

The parent may want to avoid paying taxes or the child may want the property below market value. As a result, the transaction price of the property in this example is below fair market value. Another example of a relationship is two subsidiaries of the same parent company engaging in a real estate transaction. In some cases, both parties can use a non-arm’s length transaction to defraud other parties involved in the transaction, such as a mortgage lender.

Fair Market Value in an Arm’s Length Transaction

As a result, mortgage lenders prefer to finance arm’s length transactions. There is also a higher probability that the transaction price is not fair market value. Real estate transactions between related parties must be made with arm’s length transaction prices.