ARM’S LENGTH TRANSACTION: Meaning, Process & Value 

arm's length transaction
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What is an arm’s length transaction in real estate and a non-arm’s length transaction? What does it mean, and how does it work? In this post, we’ll answer these questions and more about the steady development of new terms that real estate companies are coming up with. However, I’m curious as to what you think of when you first hear this term. There is a good chance that what you’re thinking right now is the true meaning of it. Let’s see!

Arm’s Length Transaction Overview

We mainly use the expression “at arm’s length” to refer to transactions in which two or more unrelated parties agree to do business together. However, they act independently and in their respective self-interests. Regarding the feature of this transaction, the parties involved have equal bargaining power, as well as power and information, which leads the parties to agree upon fair market terms. The opposite of this occurs between parties that have a personal or close relationship. For instance, transactions between family members, personal friends, or the parent company.

Whether you perform a business at “arm’s length” or not really matters because it will have legal and tax implications. In most countries, tax laws require holding companies to engage in business transactions with their subsidiaries at “arm’s length”. The concept seeks to guarantee fair market conditions and to see that they allocate taxes correctly for those transactions. This is for the purpose of avoiding potential conflicts of interest that may arise.

You can also call this type of business relationship the arm’s length principle (ALP), which simply means a transaction between two independent parties acting in their own self-interest. Both the buyer and the seller are independent and possess equal bargaining power. This type of transaction is a transaction that closely matches the fair market value of the consideration.

Definition of Arm’s Length Transaction

The simple definition of “arm’s length transaction” refers to transactions that are between parties who are acting independently from one another and are not associating themselves with one another outside of the transaction. By contrast, a transaction would not be “arm’s length” if the buyer and seller are personal relations like family members or personal friends. Transactions between businesses, such as those between a parent company and its subsidiary, would also not be arm’s length.

For example, when a multinational corporation engages in transactions with other companies because it has afflictions with these companies throughout the world, it ensures that those transactions are at fair market values in order to correct taxes that each jurisdiction.

Similarly, holding companies can 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 intend to encourage fair and reasonable business practices and to protect the public at large. The significant definition in an arm’s length market is that parties have no relationship or contact with one another aside from the transaction at hand.

Non Arm’s Length Transaction 

What is a Non-Arm’s Length Transaction? Real estate transactions fall into two categories in this case, and they include arm’s length and non-arm’s length. Like I said above, an arm’s length transaction occurs when two parties don’t have a professional or personal relationship. It might interest you to know that most people engage in arm’s length transactions in most businesses. This is because it is beneficial to participate in a business while also having each side act in their own self-interest.

On the other hand, a non-arm’s length transaction occurs when the buyer and seller have a personal relationship. It could be business between friends, family, or co-workers. Self-interest is not the motivation for a non-arm’s length type of transaction. For example, when parents sell their home to an adult child, or when a boss sells an employee’s property, self-interest is mostly not the motivation for selling the property to the adult child or employee. When you apply for an FHA loan, you will see a non-arm’s length transaction as the “identity of interest.”

If you are purchasing a home from a family member, you are already familiar with the home, so the closing process can be less complicated and you will most likely get a good deal. But also, it might not always, in all cases, be that simple. It is very important to do your research before you officially buy a home from a parent, aunt, uncle, another family member, or friend. This is because non-arm’s length transactions face more scrutiny than arm’s length transactions because there could be a higher chance of fraud when both sides have a relationship.

What Is an Arm’s Length Transaction in Real Estate?

As we have been discussing all through this post, arm’s length transactions can be applied in different scenarios. such as real estate and business sales, but when you’re in the market for a new property or investment opportunity, there is no arm’s length situation. The real estate arms-length transaction ensures that both parties act in their self-interest to get the best deal and that neither party exerts pressure on the other. 

You already know that an “arm’s length transaction” is a real estate term that means buying and selling with someone you are familiar with. You would commonly see an arm’s length transactions in real estate deals because the sale affects not only those directly involved in the deal but other parties as well, including lenders.

For instance, when two strangers involve themselves in the sale and purchase of a house, the final price is likely to be close to fair market value. Also, assuming that both parties have equal bargaining power and equal information about the property, then the seller would want a price that’s as high as possible and the buyer would want a price that is as low as possible; otherwise, the price is not likely to differ from the actual fair market value of the property.

Understanding Arm’s Length in Real Estate

If the parties dealing at an arm’s length transaction in a real estate deal have a direct impact on financing by a bank of the transaction and local taxes, as well as the influence the transaction has on setting arguable prices in the market, the deal is already a profitable one. An arm’s length term is majorly used in real estate, especially in the purchase of a home.

Because the independent parties are acting in their self-interest in this transaction, you will see that the seller will be pushing for the highest possible sale price while the buyer is bargaining for the lowest. It is this transaction relationship that ensures that properties are at their fair market value or the price that the property would sell for on the open market.

Majorly, as I said above, in arm’s length transactions, buyers and sellers have no pre-existing relationship. This is because, most of the time, a personal connection could prevent a business from taking place fairly, thus disorganizing the value of the property in the fair market. In this situation, one party will probably be willing to buy or sell the property for a price lower than what it would get at market value to benefit the other party. On a larger scale, dealing at arm’s length encourages fair business practices among real estate buyers and sellers, and protects the public from inaccurate pricing in the market.

Conclusion 

Now you already understand the difference between the two terms: arm’s length business and non-arm’s length transaction, so there is no general confusion between them again. Just to refresh your memory in case you were distracted while reading the post. An arm’s length in real estate is between non-relations. The opposite is a transaction between relations and familiar people. This is a common term in real estate because it pops up every time you want to perform most real estate activities. This is why you need to understand it properly.

FAQs

What are non-arm's length transactions?

A non-arm’s length transaction occurs when the buyer and seller have a personal relationship. A deal between friends, family, or co-workers is considered to be a non-arm’s length transaction. With these home sales, self-interest may not be the motivation, for instance, when parents sell their home to an adult child

What is the meaning of arm's length basis?

A transaction is generally described as being on an arm’s length basis when a buyer and a seller act independently and have no relationship with each other. The concept is used to ensure both parties in the deal are acting in their own interests and are not subject to any pressure from the other party

Does Freddie Mac allow non-arm-length transactions?

Conventional loans underwritten to Fannie Mae or Freddie Mac standards also allow for the financing of a non-arm’s length transaction but only for existing inventory and for a primary residence.

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