What is a non-arm's length transaction?

If you’re looking to buy a home and know a friend or family member who's looking to sell one, it may feel like a perfect match. After all, there are certainly some benefits to purchasing a home from someone you trust such as a shorter buying process, a familiarity with the home and neighborhood and the potential to get a good deal. In fact, it may be more common than you think. There’s even a name for it.

Purchasing a home from someone you know is called a non-arm's length transaction, and there are several considerations to bear in mind that could potentially complicate this type of deal. So, what is a non-arm's length transaction, and what should you know about them before agreeing to one?

A non-arm's length transaction defined

When the parties involved in a deal don’t know each other, it's called an arm’s length transaction. A non-arm's length transaction is a real estate transaction in which the buyer and seller have a pre-existing personal relationship. The type of personal relationship is typically not important. Some common examples include:

• A parent selling a home to their child
• Someone purchasing a home from a friend
• A landlord selling a property to their tenant
• Business partners transferring real estate to each other
• An employee purchasing a home from their boss

Non-arm's length transactions may be scrutinized by lenders more heavily to ensure there is no fraud or misconduct happening. Most lenders have additional guidelines for a non-arm's length sale in order to protect themselves.

How do non-arm's length transactions work?

From a buyer or seller’s point of view, the logistics of a non-arm's length transaction aren’t much different from an arm’s length transaction. The main difference is that there aren’t any personal factors to consider when negotiating an offer in an arm’s length transaction.

If you’re purchasing a home from someone you know, you can generally expect it to follow these steps:

1. Get preapproved for a mortgage: Before you commit to buying something, mortgage preapproval can help you make sure you know how much you can afford. The preapproval process will look at your credit score, income, debt-to-income ratio, assets and how much you have saved for a down payment. Lenders will use these to determine what kind of loan terms they’re willing to offer you and provide you with a conditional commitment.
2. Determine price: You and the seller may want to sit down and work this out together. You can look at fair market value, determine closing costs and figure out if there is any gift of equity involved. A gift of equity is provided by the seller to the buyer. It represents a portion of the seller’s equity in the home and is transferred as a credit to the buyer.
3. Hire an attorney or real estate agent: There’s some paperwork to complete that is best done by an experienced professional. Typically, the buyer and seller are represented by separate agents or attorneys to avoid potential conflicts of interest.
4. Complete the purchase offer: The purchase offer will include all information about the sale, including the price and any contingencies. You’ll need the signed purchase offer to officially apply for your mortgage.
5. Complete a title search: You may want to hire a title company to ensure there are no liens on the house title.
6. Pack your bags: It’s closing time! Get ready to move into your new space.

The process for a non-arm's length transaction is typically a bit quicker than an arm’s length transaction. This is because with the latter, there will likely be house tours, additional negotiations and competition when you’re looking for a home.

Things to consider before making a non-arm's length transaction

Before you decide to go ahead with a non-arm's length sale, you may want to understand what additional scrutiny you may face from lenders.

One concern is that the dynamic between the buyer and seller is different. In an arm’s length transaction, both parties are looking out for their own best interests. In a non-arm's length transaction, lenders risk the buyer and seller potentially collaborating at the lender’s expense. As a result, it’s likely you'll face increased restrictions from lenders during a non-arm's length transaction. This may include things like a larger down payment, but it varies depending on the type of loan you receive.

Alternatively, a non-arm's length transaction could lead to one of the parties possibly exploiting the existing trust to take advantage of the other. For instance, a seller could be tempted to lie about the fair market value of the home, hoping the buyer trusts them enough not to question it. This isn’t just unethical — it may also constitute mortgage fraud, which lenders and authorities treat very seriously.

Mortgage underwriters will also give non-arm's length transactions a closer look to ensure that no mortgage or tax fraud is being committed, there is no additional risk exposure to the lender and that neither party is acting unfairly.

Pros and cons of a non-arm's length sale

One way to help you decide if a non-arm's length sale is a good idea is to weigh the pros and cons.

Pros:

• The buyer may be able to receive a gift of equity from the seller, which could potentially reduce the down payment.
• If the sale is completed without real estate agents, you may avoid brokerage fees.
• There may be a sentimental reason to keep the home within a family or between friends.
• The process overall is typically quicker than an arm’s length transaction.

Cons:

• If you receive a gift of equity from the seller, the seller will have to fill out a gift tax form if the gift is worth more than the IRS limits for gifts.
• Financial deals can cause tension between people. Try and treat the process as a business transaction to avoid jeopardizing your relationship with the other party.
• There are increased restrictions and hurdles in the mortgage process during a non-arm's length transaction.

In summary

The next time someone asks, “What is a non-arm's length transaction?”, you’ll hopefully be able to tell them: It’s a transaction where both parties have a pre-established relationship outside of the sale. Ultimately, it’s up to you if you want to pursue an arm’s length transaction. It could be a good option if you know someone looking to sell a house that you’d be interested in purchasing. The process will likely be quicker and you could get a better deal. However, keep in mind the stress that financial deals can put on a relationship and remember that you’ll both be under more scrutiny during the mortgage process.

Non-arm's length transaction FAQs

1. What are the risks of a non-arm's length transaction?

A non-arm's length transaction may put a strain on the relationship between the two parties and may open the seller up to a tax event because of the gift tax form. For lenders, there is an increased risk of fraud if both parties are in collusion (which is generally facilitated by having an established prior relationship).

2. Are non-arm's length transactions illegal?

No, non-arm's length transactions are not illegal. However, due to the increased risk of fraud, they are generally more heavily scrutinized by lenders during the mortgage process. There is also the potential for one party to exploit the other’s trust in them, which is why it helps for each side to have their own representation in the form of separate attorneys or real estate agents.

3. Does FHA allow non-arm's length transactions?

Yes, but there are more requirements by the FHA during a non-arm's length transaction. One of these requires a 15% down payment, rather than the standard 3.5%. Consult an FHA loan professional to learn more.