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Have you heard of the phrase “an arm’s length transaction?” Although you may not have heard of this transaction often, this type of transaction is more common than you may think.
Below we’ll clearly explain what it is. Additionally, we’ll also highlight some drawbacks and advantages with an arm’s length transaction.
What is an arm’s length transaction?
An arm’s length transaction (also known as arm’s length principle) is a transaction that occurs between two strangers because they aren’t related, and they don’t tend to have any pre-existing relationship. An arm’s length transaction also ensures the buyer and seller receive a fair market deal, benefiting both parties thinking of their own self-interest.
For example, a person wanting to sell her home to a stranger won’t feel obligated to price their property less because of personal feelings about the buyer.
How does an arm’s length transaction apply to real estate?
When it comes to an arm’s length transaction in real estate, the owner and the seller rarely communicate. They may see the other person at a showing or during the closing, but they’re generally won’t be any interaction. Additionally, communication is commonly between the seller’s agent and the buyer’s agent.
Because of this, they are only concerned with their self-interest. Therefore, the other parties act independently, and their feelings do not factor in the agreed-upon price.
This transaction can reduce the buyer or seller’s pressure to benefit the other party, allowing equal bargaining power. For example, the seller will often try to get the highest price possible for their property, and the buyer will try to pay the least amount for it.
Why is an arm’s length transaction important
Arm transactions are essential in real estate because each party will act in their own best interest without feeling guilty. However, in other transactions, a party may do what’s best for the other party rather than what’s best for themselves. Because of the conflict of interest, sellers could lose out on a lot of money or sell a property they weren’t ready to let go of.
It is also important because it will often impact whether or not the seller will sell the property at actual fair market value. The seller won’t give the buyer a huge discount because they know or are related to them. Because they have no personal relationship, they often set the asking price close to the market price.
Arm’s length transaction example
An example of this type of real estate transaction is when a homeowner can no longer make mortgage payments. Thus, they to avoid foreclosure through a real estate short sale. To satisfy the mortgage lender, homeowners will embark on a short-sale transaction to interested buyers to quickly pay off their mortgage.
According to the arm’s length transaction definition, the seller does not have an existing relationship with the buyer. Typically, the real estate buyer is someone they’ve never met before and usually someone into real estate investing looking to expand their real estate portfolio.
Another example is when a seller lists a home for sale online or through a real estate agent. This type of transaction is reasonably common for real estate deals as many people buy or sell real estate to someone even though they have never met them before.
Arm’s length transaction vs. non-arm’s length transaction
One of the most significant differences between an arm’s length transaction and a non-arm’s length transaction is the selling price of the property. In a non-arm’s length transaction, the seller will often sell the house for less than they want because they sell it to someone they know.
In an arm’s length transaction, the seller won’t consider how much the buyer can afford. Instead, they want to get as much as they can for their property.
In a real estate market where there’s not enough inventory, some sellers will try to sell their home for more than what it’s worth as they will tend to have numerous independent parties interested in their property.
Tax implications of an arm’s length transaction
There are tax laws that were created that will ensure that the seller pays a fair amount in taxes no matter how much they sell their property for. Sellers have to pay taxes based on the property’s fair market value even if they sell it for less than what it’s worth. Therefore, sellers don’t have much incentive to sell their home for less than its fair value to the other party.
For example, if their home is worth $300,000, they would have to pay capital gains taxes to the IRS based on its value of $300,000, even if they sold it for $250,000. Because of this, there is no benefit of the seller not selling their property for what it’s worth. If they do, they can lose out on a lot of money to the tax authorities.
How arm’s length transaction ensures fair market value
Because the seller and buyer are on neutral ground, the home’s selling price will usually be right around the fair market value. It’s not uncommon for a seller to price their home for more than it’s worth and end up changing the price as soon as a potential buyer gets it appraised and finds out what the home’s fair market value is.
Sellers need to keep in mind that the value of their homes can change drastically from year to year, which often happens for various reasons such as the age of the house, neighborhood comps, interest rates, or the availability of similar homes on the market.
It is important to note that non-arm’s length transactions can impact other homes’ value in their local area.
For example, a seller that sells a home to a friend, relative, or family member at a price that’s a lot less than its worth can impact what other sellers set the price of their home when they put it up for sale. Because many sellers tend to look to see how much similar homes have sold for in their neighborhood, they may price their home for a lot less than what it’s worth.
An arm’s length transaction ensures that the two parties involved receive a fair deal and, and after some negotiations, the homeowner sells their property at the fair market value. Selling a property at market value may sound obvious, but some friends and family members are looking for a special discount.
For instance, after a friend got married, he decided to move in with his wife and rent out his house. His sister ended up renting out the property and eventually wanted to buy the property from him. However, she pointed out that her brother purchased the home for a particular price ten years ago and asked to purchase it from him for the same price.
If the brother were to give her a significant discount, the compensation may impact the market value of the homes in the area. Therefore, regardless of the brother’s good intentions, this kind of gift can hurt a seller’s appraisal in the future.