The Non-Arm’s Length Transaction
Most home purchases are arm’s-length transactions. That is, they normally happen between people who didn’t know each other before the house sale. When strangers sell and buy, each side is motivated to negotiate in a self-interested way. This tends to result in a price (and mortgage) that reflects the home’s fair market value.
But sometimes friends, relatives, or business associates sell real estate to each other. A parent might sell to a child, or vice-versa. An owner might sell a rental house to a tenant. A company might sell a house to someone it employs.
The dynamics of these transactions differ from the norm. On one hand, the process can be simpler. On the other hand, it can be hard to diligently inspect and negotiate for property, or sell it for the right price, when personal relationships are implicated.
Here, we walk through a few of the potential benefits and drawbacks in a home sale between people who know each other.
Potential Upsides to the Non-Arm’s Length Deal
A transaction between related people can be the opportunity of a lifetime for a buyer — especially in a competitive real estate market. The seller might be prepared to give up money that bidders on the open market would have offered over the asking price. And a seller who knows a buyer might also be willing to offer a seller-financed purchase or a short-term rental agreement as part of the deal. Seller financing can make home ownership happen if a standard loan approval isn’t possible.
In a seller-financed deal, the buyer and seller sign a promissory note detailing how the loan will work. Then they record the promissory note.
Owner financing may be issued through an owner-carry mortgage or under a security deed. If a mortgage is already on the home, the seller may be able to offer a wrap-around loan.
☛ Find out more about seller financing, including the all-inclusive mortgage or deed of trust (which one you get depends on the state).
With seller financing, the buyer avoids the typical loan origination and underwriting fees. And the seller will have a source of regular, monthly income as the buyer pays for the home over time.
How Mortgage Lenders Steer Clear of Pitfalls
Getting a commercial lender to finance the deal? Lenders want to know that they’re involved in financing a fairly priced real estate asset. That’s why transactions between related parties are not so simple from the lender’s perspective.
Sometimes, people in trusting relationships try to sell the home at a higher price than what the market can bring. Sometimes, they do the opposite: they’ll discount the price of the house for a buyer they know.
If a friend, business associate, or relative sells to the buyer for a price below the home’s appraised value, the difference becomes a gift of equity. Many lenders allow this to be used in the down payment.
A seller is allowed, under federal tax provisions, to make a “gift” amounting to $15,000 (double that when a couple is selling) without having to pay gift taxes.
☛ Learn more about how a gift of equity works, on Deeds.com.
Lenders expect fair market value to be paid and documented in any transaction. Their aim is to ensure the home is purchased under terms that would prevail in the open market. Expect the lender to apply special scrutiny to the non-arm’s length transaction. This is what’s called applying the arm’s length principle, which requires a fair property transfer price, amounting to the appraised value. Applying safeguards helps to keep the deal fair for both sides, prevent undue pressure on one family member by another, and avert even the appearance of mortgage fraud.
How the Conditions and Terms of Financing Can Vary
The terms of financing in non-arm’s length transactions can vary, depending on whether the buyer goes with a conventional loan or a government-backed loan. Going with an FHA loan? Many people do.
The FHA refers to an identity of interest if a relationship exists between the seller and the buyer. Off the bat, there’s a presumption that connected parties won’t expect a fair-market price for the home. Why? Because the property isn’t being sold to the highest bidder, but to a hand-picked buyer instead.
To get the lowest down payment available on an FHA loan (that is, to put as little as 3.5% down), the buyer would be:
- Purchasing the primary residence of a family member, fiancé, or domestic partner.
- Purchasing from a landlord or family member after living in the home at least six months.
- An employee purchasing a house from an employer who is moving the job.
Otherwise, the FHA’s required down payment could shoot up to 15%.
Before the Purchase: What You Will Need
Here are the common documents necessary for a home purchase:
- The house title and most recent deed. Be sure mortgage and other liens, and any open permits, are taken care of before the transaction.
- Local property tax statements.
- The homeowner’s insurance policy.
- Condo or association rules and related documents, if applicable.
- The most recent property survey and inspection reports.
- The seller’s disclosure form, completed as required by state law.
Then the parties will create a new warranty deed and have it recorded. The county recorder of deeds office can supply the proper procedure and let the parties know what other forms must be filed with the deed.
Reducing Risk for Both Parties by Getting Professional Assistance
Even if the buyer and seller want to create a deed themselves, they can have the loan documents and purchase agreement drawn up by pros. Real estate professionals can reduce risk by assisting the parties and applying arm’s-length transaction practices.
An appraiser determines the home’s fair market value with precision, and a real estate agent examines market conditions to produce a current assessment of fair market value. Agents also help the parties create a sales contract that includes important contingencies.
Hiring a title company can alert the buyer to any existing claims on the title. Title companies have for sale by owner departments to support transactions that don’t involve agents, should the parties decide on an FSBO transaction.
If financing is involved, the lender will require title insurance. Buyers should additionally consider the benefits of purchasing an owner’s title policy.
Also, consider going over the planned transaction with a tax expert. Tax officials scrutinize sales and purchases. They expect a homeowner to have paid a fair value, and to have an appropriate loan and deductible interest amount. This means even after the parties wrap up their transaction, tax officials can still question whether a non-arm’s length transaction was correctly handled.
And paying too little for a home can lead to a hefty tax bill the next time the title is transferred, on an oversized profit. That said, for a primary residence, an owner can usually claim an exemption (currently up to $250,000) on the capital gain from the house sale.
The Key Takeaway
Home purchases between people who know each other can be perfectly fine, but don’t expect a steal! And gear up to have special scrutiny applied to a non-arm’s length purchase.
Please note: This article is offered as general information for Deeds.com readers and is not a substitute for the case-specific advice of a real estate attorney.
Supporting References
Deeds.com: The Seller-Financed Home Sale: Weighing the Risks and Rewards (Jul. 6, 2020).
Patrick Chism for QuickenLoans.com: Buying a Home from a Family Member: Non-Arm’s Length Transactions (Jul. 15, 2021).
Photo credits: Andres Ayrton and Brett Sayles, via Pexels.