A non-arm’s length transaction occurs when you buy property from a relative, friend, or someone with whom you’re in business. Lenders may impose stiffer requirements for mortgage loans for non-arm’s length real estate transactions because there’s a greater chance of price manipulation due to the existing relationship between the buyer and seller.
However, if someone you know wants to sell a home and you want to buy it, you might benefit from a non-arm’s length transaction. Read on to learn what you should do to buy from a friend or relative while avoiding the pitfalls of a non-arm’s length sale.
What is a non-arm’s length transaction?
A non-arm’s length transaction is a real estate sale between people who have a close relationship, such as being family or business partners. When there’s a close relationship between the parties, they may be less likely to negotiate the sale price, so they’re less likely to settle on a fair market value.
Non-arm’s length real estate transactions typically occur between family members or friends. For example, a grandmother might sell her house to her grandson for a discounted price. Such a transaction is allowed, but it might raise tax issues.
What is an arm’s length transaction, and why do lenders prefer them?
An arm’s length real estate transaction is what most of us picture when we think of the typical home sale. The buyer and seller have no prior relationship, and they both act in their own interest to reach the best price for themselves.
The differences between a non-arm’s length sale and an arm’s length deal come down to:
- The relationship between buyers and sellers.
- Whether the parties are operating in their own best interests to get the most competitive price, or whether they may settle on a price that differs from what the home would sell for on the open market.
Lenders prefer making a mortgage for an arm’s length purchase because the sale is more transparent, and the two parties likely have settled on a fair market value. With a non-arm’s length sale, on the other hand, there is less transparency. Lenders worry the two parties may have hidden some terms of the deal, such as the seller providing the buyer with money for a down payment. In a short sale, where the property sells for less than the seller owes on the mortgage, lenders may be concerned that a relative could purchase the house and sell it back to the original seller, which could constitute mortgage fraud.
Because of these concerns, lenders may impose greater restrictions on mortgages for non-arm’s length transactions, which are also called identity of interest transactions. For example, in some circumstances, FHA loans require a minimum 15% down payment for a non-arm’s length sale, compared to a minimum 3.5% down payment for an arm’s length sale.
How to properly conduct a non-arm’s length home purchase with family
You may want to buy a house from a relative for many reasons, including because you think you’ll get a good deal on the home. For instance, you may want to purchase a home from your uncle because you know the property has been renovated and is well-maintained. Or, you might want to buy your parents’ house to keep it in the family while allowing them to purchase a smaller home.
To avoid triggering any alarms about non-arm’s length deals, you’ll want to handle the sale the same way you’d approach buying from or selling to a stranger.
Tips for sellers
Even if you’re selling your home at a reduced price to your son or daughter, it’s important to establish the property’s fair market value and file the right documents. If you sell the property at a discount, you may be giving your relative a gift of equity by transferring some of your equity in the home to the relative. The recipient can use the value of the equity as the down payment for the home.
For instance, if the parents’ house is worth $400,000 and they sell it to their daughter for $300,000, they’re giving her a $100,000 gift of equity. As a result, she now has a $100,00 down payment.
When you gift your equity in the property, you may be subject to federal gift tax rules. Each donor can exclude from taxes the first $16,000 given to a recipient for the calendar year. (The $16,000 limit applies for tax year 2022; the amount is adjusted annually for inflation.) A married couple can split the gift to increase the amount excluded from taxes to $32,000 annually. U.S. tax law allows individual donors to exempt more than $12.06 million in gifts over their lifetime and through their estate as of 2022.
Consult a tax specialist to see how giving a gift of equity would affect you and to make sure you file the proper paperwork. You may have to file even if no tax is due.
Beyond dealing with tax concerns, sellers in a non-arm’s length deal should:
- Hire a real estate agent or attorney to ensure the sale is handled correctly.
- Get a home appraisal to determine the home’s value. If you’re giving a gift of equity, you’ll need an official appraisal.
- Have a formal purchase agreement with the buyer spelling out all the details.
- Check with a tax specialist about the gift tax or other taxes you may own.
Tips for buyers
If you’re the buyer in a non-arm’s length transaction, consider hiring a real estate agent or attorney to help you — especially if you’re buying for the first time. There are a lot of details to keep track of, even when you’re buying a house from a family member that is paid off, and a professional can help you make sure you’ve taken care of everything.
Buyers should take the following steps:
- Get preapproved for a loan. Not every lender will grant a mortgage for a non-arm’s length home purchase, so shop around. You may have to get an FHA loan, but if you buy from a family member and plan to live in the home, you’re exempt from the 15% down rule
- Get a home inspection. You need to know what you’re buying, even if it’s the family home. A professional inspector can assess the condition of major systems, look for maintenance issues, and help you budget for upcoming work the home may require.
- Check for liens on the house. This will take place during a title search. A specialist will look through public records like deeds and court records to make sure the seller has the right to sell the property. The title search also looks for liens and judgments, such as unpaid taxes or liens filed over unpaid bills. Your relative may be unaware of any liens or may have forgotten about them.
When are non-arm’s length transactions legal vs. illegal?
A non-arm’s length sale is legal as long as neither party is trying to commit fraud or evade taxes. The government clearly spells out typical non-arm’s length deals that are eligible for FHA loans with less than 15% down. Those include:
- One member of a family buying a home from another to use as a principal residence.
- A builder’s employee buying one of the builder’s new homes for a principal residence.
- Tenants purchasing the property they’ve rented for at least the last six months.
- A corporation purchasing a property from an employee who is being transferred, then selling the home to another employee.
A non-arm’s length deal becomes problematic when one or both parties intend to deceive. For example, say the buyers get the house at a below-market price and record that price as the value of the home in hopes of a lower property tax evaluation. That could be a form of tax evasion.
How to maintain compliance in a non-arm’s length transaction
The best way to ensure compliance in a non-arm’s length sale is to seek advice from professionals. For example, you may consider taking the following actions:
- Getting an appraisal to establish the fair market value of the home.
- Consulting a tax professional to ensure you meet all of the gift tax requirements and file the proper paperwork.
- Telling the lender about the relationship between the buyer and seller.
- Having a formal sales contract that spells out the details of the deal.
Wonder what size mortgage you qualify for? Talk to a local Finance of America Mortgage Advisor today to learn more about your options.