Have you ever heard someone use the term arms-length transaction or non-arms length transaction before?
It's a strange bit of terminology people use in the real estate business, but these terms have
a very important meaning that can have big consequences when it comes to
the valuation, financing and taxation on any piece of real estate.
So, what do these terms mean?
And what's the difference between the two?
An arms-length transaction happens when a property is sold
and there is no pre-existing relationship between the two parties of the deal.
The buyer and seller are acting independently and they aren't connected or affiliated
by family, marriage, or any other kind of business relationship.
If a buyer and seller are unrelated and have no prior relationship or obligations to each other
it can generally be assumed that the two parties are acting in their own best interests.
The buyer is trying to get the lowest possible price and the seller wants to get the highest possible price
and whatever price they both agreed upon
was an accurate representation of the property's fair market value.
In other words, it was a normal deal.
Now, on the other hand, a non-arms length transaction is when there is an existing relationship
between the buyer and the seller, or there is an unusual circumstance that is causing
the sale price to be artificially low, kind of like a parent giving property to their child
or a brother selling a property to their sister at a lower price.
A non-arms length transaction typically happens when one of the parties
has a special interest in the other party's well-being.
It can also happen if the property is sold under duress causing the sale price to be lower than normal.
One way to remember the difference between an arms-length and a non-arms length transaction
is to imagine two people standing next to each other.
If the two people are standing further apart from each other, by their arms-length or further
by this outward appearance, we could assume that these are two unrelated people
doing business under normal circumstances.
However, if you see two people who are standing unusually close together,
say if they're standing shoulder to shoulder or they have their arms around each other, by all outward appearances
one could reasonably assume that the two people probably know each other or they're close enough
that they might treat each other with more kindness and familiarity
than they would to any old stranger they'd meet on the street.
So why does this matter?
Whether a deal is arms-length or not arms-length?
Well, there are a few important reasons for this.
First of all, the properties assessed value is based on the transaction price.
And if that price is lower than it normally would've been, if the property had been sold
in a normal arms-length transaction, the assessor is going to need to know about this
so they can make adjustments and ensure the assessed value stays accurate
reflecting the property's true value, not the artificially lower value shown in a non-arms length transaction.
And the assessed value of a property will determine future property tax amounts for the owner.
And it can also have big implications for taxation from the IRS on investment properties.
This can also be a factor when a bank is dealing with a short sale and a short sale happens
when the bank is one of their borrowers to sell-off their property, which is the bank's collateral
for a price that is less than the amount owed on the loan balance,
which results in a loss or a smaller return to the bank.
And if a bank is aware that a short sale is happening between two related parties,
this is usually a pretty good indication that the property isn't being sold at its fair market value.
And in most cases, this would cause the bank to step in and stop the transaction
or verify by some other means that the sale is indeed a normal arms-length transaction,
where the two parties do not have any preexisting connection or relationship.
And appraiser will also want to verify whether a property sale was arms-length or non-arms length
because part of what they do when they value properties is to look at comparable sales in the near vicinity.
And when they look at these comparable sales in the market
to support the value of the property they're evaluating,
it wouldn't be appropriate for them to use a comparable sale price
that was a non-arms length transaction, because this isn't an accurate portrayal of
the property's true market value.
And speaking of appraisals, whatever value and appraiser comes up with for the subject property
this value also affects how much can be borrowed against that property.
So it's important to get this number right.
So let's cover some of the most common situations when a non-arms length transaction comes up.
Probably the most obvious example is when a parent sells their property to their child
at a below-market price or any similar deal between family members.
And as we mentioned earlier, it can also happen when someone sells a property in a short sale to a related party.
A short sale isn't always considered a non-arms length transaction,
but it should cause a bit more scrutiny from the lender to make sure they aren't getting
defrauded by a borrower who just doesn't want to pay off their full loan balance.
Another example is when someone does a double closing, when the first transaction is clearly a much lower
than the second transaction that occurs immediately thereafter
and a non-arms length transaction can also happen
when someone sells their property to a business partner
at a discounted price in exchange for some other value,
apart from the real estate transaction, or just because they have a close relationship.
And non-arms length transactions can often happen when a property is being sold
along with other properties that come with it.
Like for example, if somebody buys a house at or above its fair market value,
but then the seller also includes a vacant lot right next to it for $1 instead of its full market value
it could even happen to when a tenant is buying their property from their landlord.
Say, for example, if it's a long-term tenant who is close with their landlord
and the landlord lowers the price as part of a rent to own scenario.
So now that we clearly know the difference between an arms-length and a non-arms length transaction,
how can you verify that a transaction is actually a normal arms-length sale?
Well, in most normal property transactions that occur through the MLS and are facilitated by a licensed real estate agent,
if the price looks normal and there is no reason to think the buyer and seller know each other,
then there's usually no additional scrutiny put on the deal to verify that the parties aren't affiliated,
because it's fairly obvious just looking at the facts.
But if there's ever any doubt or uncertainty about whether or not a deal is an arms-length transaction,
another way to verify this is to have the buyer and the seller,
and maybe even their realtor sign an affidavit under penalty of perjury
so it's very important that they're not lying testifying, that there is no relationship between the two parties.
If you want to learn more about the difference between an arms-length and a non-arms length transaction,
be sure to check out the full article at retipster.com
which you can find links right beneath this video.
And if you want to expand your real estate knowledge,
be sure to check out this next video and we'll see you there.