Key Takeaways
- Arms-length transactions ensure fair market value for buyers and sellers.
- Lenders prefer arms-length deals to prevent inflated property prices.
- Non-arms-length transactions may require additional lender scrutiny.
- Such transactions are crucial for accurate property appraisals.
Article Summary
An arms-length transaction in real estate is a purchase in which the home buyer and seller are unrelated in their business and personal lives. This ensures a fair market value for the home.
Arms-Length Transaction: Explained in Plain English
An arms-length transaction in real estate is when a home buyer and seller agree on a deal and have neither a business nor a personal relationship.
Because the buyer and seller do not know each other, it signals to the mortgage lender and other parties that the home's sale price reflects current market conditions.
As an illustration, let's consider two scenarios.
In the first scenario, a first-time home buyer purchases their childhood home from a parent at a reduced price as a favor. This purchase would fail the arm's-length transaction test because the relationship between the buyer and seller likely influenced the property's sale price.
In the second scenario, a first-time home buyer purchases a move-in ready home from a builder who is developing homes in a desirable neighborhood. This purchase would pass the arm's-length transaction test because the sale price is based on the home's condition, location, and comparable home sale prices in the area.
Examples of Arms-Length Transactions
| Scenario | Is It Arms-Length? |
|---|---|
| Buyer purchases a home from an unrelated seller | Yes |
| Parent sells a home to their child | No |
| Investor buys a property from a bank | Yes |
| Landlord sells to their current tenant | No |
| Buyer purchases a foreclosure at auction | Yes |
Arm's-length transactions are more likely to be approved for mortgages because non-arm's-length transactions introduce lending risks. Lenders cannot determine a property's fair market value when a child buys a home from a parent or a cousin buys a home from a cousin.
Non-arm's-length transactions are considered red flags in mortgage approval. Only an arms-length sale gives lenders confidence that a fair market valuation supports the loaned amount.
Questions Home Buyers Ask About Arms-Length Transactions
Common questions about arms-length transactions and how they affect mortgage approval.
Why do lenders care whether my purchase is an arms-length transaction or not?
Lenders care about arms-length transactions to ensure the property's value is market-driven and unbiased. Personal ties may distort property values, increasing lending risks.
Can any transaction between family members be considered arms length?
Transactions between family members are typically not considered arms-length because personal relationships may influence terms and pricing, leading to potential biases. An arms-length transaction requires both parties to have no personal ties, ensuring decisions are purely market-driven.
How can I prove my home purchase transaction is an arms-length transaction?
To prove an arms-length transaction, demonstrate there are no personal ties between buyer and seller, use a home appraisal and market analyses to validate terms and pricing, and negotiate through an impartial third-party, such as a REALTOR or attorney.
Can a non-arms-length transaction impact mortgage approval?
Yes, mortgage lenders scrutinize non-arms-length transactions, which may affect loan terms, property valuation, and approval due to potential conflicts of interest.
What are some examples of relationships that are non-arms length transactions?
A few non-obvious examples of non-arms-length transactions in real estate include a property manager buying from a landlord they represent, a real estate developer buying a home from a contractor they frequently employ, a landlord selling to their tenant, a neighbor selling a home without an impartial intermediary, and a real estate agent buying from a client they have previously advised or represented.
