If you're buying a relative's house, you may have heard the term "arm’s-length transactions." Here's what you need to know about them, and how to keep from getting the short end of the stick when using them.
A transaction between two people who have a vested interest in each other is called an arm’s-length transaction. Vested interest means they have a special interest or involvement with the other party. This could mean they are related or have some close connections. The buyer and seller have a relationship, but try to keep the transaction as professional as possible (at arm's length).
Typically when a homeowner sells their house in an arm’s-length transaction, they'll sell their house for close to what they actually paid for it, rather than what they could sell it for on the open market.
An arm’s-length transaction occurs when two parties who have a relationship with each other want to broker a deal on a house. Because of their relationship, they likely want both parties to benefit, so they may alter the sale price to be as close to—or even less than—the base amount that the home is worth. The price then becomes more of a family and friends discount.
Tax Implications of Arm’s-Length Transactions
Buying or selling a house to family members, a company, or even close friends can be an unnerving situation. As if bartering prices with friends and family isn’t stressful enough, arm's-length transactions also involve a branch of the government that no one wants to get on the wrong side of: the Internal Revenue Service (IRS).
The IRS wants to know how homeowners are handling their big assets, such as when one is buying or selling a house. The homeowner may view the transaction as a gifting process, but if the home is more than just a gift, the IRS is going to figure it out.
For example, let's say the homeowner gives a family discount of 25% or less off-market price and then only pays a gift tax on the sale. The IRS views this as trying to avoid federal estate tax by giving away the asset.
To make sure you are doing everything by the book, it's important to hire a lawyer. They'll be able to help guide you and the new homeowner through the arm's-length transaction without bringing the wrath of the IRS upon your head.
Protection During an Arm’s-Length Transaction
Although you are dealing with friends and family, there are still ways that the deal could turn sour quickly. The way to protect yourself if you’re involved in an arm’s lengths real estate transaction is to hire a professional appraiser (or a real estate broker if the buyer is not using a loan) to have a true value of the property appraised and ready for the sale.
The appraiser is an important part of the transaction, as the buyer and seller will agree upon a price based on their recommendation. Because of this, it is important that you choose an appraiser that has no connections to either the buyer or seller.
When meeting with a real estate agent or lender, it is important that you are honest about the relationships of all involved parties. When involving family or close personal relationships in a real estate transaction it is imperative to submit all of the proper paperwork.
It's easier to commit fraud with someone you know because the deal doesn't really seem like a transaction. Protect yourself against the temptation of fraud by preparing and submitting all of the proper paperwork on time and under the supervision of a knowledgeable real estate agent.
The paperwork required for this type of transaction includes
- The contract
- An appraisal of the property
- The affidavit of arm’s length This is primarily used in a short sale transaction to show that both parties are at arm’s length and not acting in the benefit of one or another. Often, in distressed situations like those that lead to a short sale, buyers will try to alter the terms of sale in their favor.
- An independent verification of the transaction
What is a non-arm's-length transaction?
There is also a non-arm’s-length transaction (aka arm-in-arm transaction). This is when two parties (such as a company, parent, or other family members) have a vested interest in the deal to help each other.
It is similar to an arm’s-length transaction, except rather than treat each other as uninvested third parties, they acknowledge they have a relationship and want to alter the deal based on that.
An example would be a father and son and the father is selling his home to his son. The father has a vested interest in his son and the father may want to give a deeply discounted price to his son for the home. This is one real estate deal where an individual would want to act independently as they sell their home.
An arm-in-arm transaction can transpire when a father and son make a deal for the son to buy the house to keep it in the family. The son may not be able to afford the family home, so the father makes a special deal with his son. This technique, while common, can be tricky because it opens the door to fraud and/or certain tax consequences.
Why are non-arm’s-length transactions a problem?
Although non-arm’s-length transactions are legal, they have been known to cause issues such as error or fraud.
When you work at an arm’s length, you agree to treat the other party (generally a friend or relative) as you would an unknown third party. When you treat them like a third party, you usually won’t alter your price or statements to benefit the other party.
Working with a non-arm's-length transaction means you will not treat the other party the same way you would treat buyer Joe who wants to buy your house. Because of this, you’ll often be tempted to “make them a deal” or alter your statements to benefit both of you. Sometimes altering the price and documents can be perfectly fine, but other times (such as when you agree to pocket some of the money without declaring it) things are not so legal.
Prevent the temptation to fudge the deal by everything documenting everything for the lender and all parties involved with the transaction.
One of the most important elements of real estate buying is keeping your own self-interest in mind. In a real estate transaction that involves a relative or friend, it's easy to keep those you love in center-of-mind. If those lines get blurred in the transaction, however, it may have ramifications for you, your family, and the lenders. Both parties must be willing to comply with all requirements for an arm’s length transaction to be successful.
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