Real estate transactions can be quite complex at times. Between the numerous tax laws and deferment strategies, lengthy purchase agreements, and extensive lease contracts, real estate investing for beginners can feel overwhelming without the guidance of a professional. Having said that, there are several aspects of real estate deals that are simple and easy to grasp. A good example of this is the distinction between an arm’s length transaction and a non arm’s length transaction. In this article, we will give you a detailed overview of these types of transactions and outline the main differences between them.
What Is an Arm’s Length Transaction?
As the name suggests, this is a transaction where there is no close relationship between the property buyer and the property seller. In an arm’s length transaction, both parties act in an independent manner. More importantly, they act in a way that places their own self-interest above all else. The lack of a relationship between the buyer and the seller guarantees more objectivity and ensures that neither side is compromised. Both sides of the real estate transaction have access to the same exact information and no party has an edge over the other.
Here’s a brief overview of some of the key characteristics of an arm’s length transaction:
- The buyer and the seller of the investment property don’t have familial or friendship links to one another.
- The objective nature of this type of transaction ensures that the price of investment properties is in line with market value.
- Transactions that occur between companies whose shareholders are related are not categorized as arm’s length transactions.
The Benefits of an Arm’s Length Transaction
An arm’s length transaction offers a number of benefits to all the concerned parties. Here’s a brief look at two major positive implications of these transactions.
1- They are easier to finance
The most obvious advantage of doing an arm’s length transaction is the ease with which you can obtain a loan to finance it. This is due to the fact that mortgage lenders tend to be less scrutinizing when dealing with these types of transactions. Real estate deals involving unrelated parties leave no ground for suspicion or reticence since every element of the transaction is above board.
2- Estimating taxes is a straightforward process
When buying and selling property, it’s essential to have a rough idea of the taxes that are associated with the transaction. Since arm’s length transactions are valued according to fair market value, estimating taxes is a simple matter of checking local tax laws and regulations. This is in stark contrast with cases where the deals are below market value. In these situations, the IRS can levy extra taxes and even impose capital gains taxes when you put up the property for sale. You can use an Airbnb calculator to see how the taxes and other expenses will impact the rental income from your rental property.
Related: Learn How to Do Taxes on an Investment Property
What Is a Non Arm’s Length Transaction?
In real estate investing, a non arm’s length transaction refers to any deal that involves related parties. This includes everything from friends and family members to colleagues and business associates. While these transactions aren’t inherently unscrupulous, the close association between the two parties creates room for manipulation. For example, someone selling a house might charge an unaware buyer a price that’s not in line with market value. A buyer can also just as easily manipulate an inexperienced seller. In other cases, both parties can engage in a sham residential transaction with the sole purpose of defrauding mortgage lenders and tax authorities.
This is not to say that a non arm’s length transaction can’t be a convenient option. If done correctly, a deal between two related parties can be extremely smooth. Below is a look at some of the best practices that you have to abide by when buying an investment property in a non arm’s length transaction.
Tips for Doing a Non Arm’s Length Transaction
- Retaining the services of a qualified legal advisor is highly recommended. Even if both parties have good intentions, a simple oversight might lead to some major legal ramifications. An attorney can help you navigate the process without having to worry about every minor detail in the deal.
- Consider hiring a title company to ensure protection against any unpaid debt that might be attached to the real estate investment property.
- Make sure that the property owner is not severely behind on mortgage payments.
It’s important to remember that a non arm’s length transaction is perfectly legal. As long as you follow the guidelines outlined above, a deal can be quickly finalized without any issues.
Related: The Best Tips for Buying Rental Properties That You’ve Ever Heard
The Major Differences Between the Two Transactions
There are several noticeable differences between the two types of transactions. Let’s go over some of the key aspects in which they differ.
Financing the transaction
Like we mentioned earlier, financing an arm’s length transaction is easier. Mortgage lenders prefer to avoid transactions between related parties in order to avoid fraud attempts. To finance a non arm’s length transaction, you will have to go through a much more thorough loan approval process.
Related: Real Estate Investment Financing: 7 Ways That Work for Beginners
Effects on personal life
Transactions that occur between unrelated parties have no implications on the personal relationships of the two parties. Conversely, a deal between two close individuals can create tension in some cases. For example, the transaction might elicit the jealousy of friends and family members who were not part of the deal.
The sheer convenience of the deal is one of the few advantages of a non arm’s length transaction. Whether you’re buying or selling a property, the process will likely be quicker. You also don’t need a real estate agent to conduct the transaction. The obvious caveat here is that there should be immense trust between the two parties.
The Bottom Line
Regardless of which type of transaction a real estate investor is conducting, it’s essential that both parties understand every facet of the deal. Seeking the assistance of a professional can help streamline the transaction for both the buyer and the seller.
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