There can be many benefits of buying a home from someone you know. Whether it’s a family member or a friend, you are likely to get the home for a better price, plus you probably know the condition of the home better. Before you get too excited about buying a family member or friend’s home, though, you should understand the rules of the non-arm’s length transaction.
What’s an Arm’s Length Transaction?
Before we dive into what a non-arm’s length transaction is, let’s look at an arm’s length transaction. An arm’s length transaction occurs when you buy a home from someone that you do not have a prior relationship with. This means that you are not family, but it also means that you didn’t know one another before, whether as a friend or business relationship. In short, the seller of the home is a stranger to you.
The Non-Arm’s Length Transaction Defined
A non-arm’s length transaction, though, is a sale between two people that know one another. It doesn’t have to be just family members either. You could have a professional relationship or even just be friends, but the fact is that you knew one another prior to the sale of the home.
If there is any type of non-arm’s length relationship involved, it could make the mortgage process tricky. There are different rules that apply to those that know one another but go into a real estate deal together.
Dealing with a Non-Arm’s Length Transaction
So what if you want to buy a home from a relative or someone you had a business relationship with at one point? You’ll have to tread very carefully.
For starters, your lender will treat the situation with extra scrutiny. The biggest concern is whether you will pay more for the home than it’s worth. Luckily, since you are getting mortgage financing, there will be a professional appraiser involved. He won’t let the buyer pay more than the home is worth because the report goes directly to the lender. The lender will not provide funding that exceeds the value of the home. For example;
If you agreed to buy a home for $300,000, and were borrowing 95% of that with a conventional loan, but the appraiser comes back and says it’s worth $200,000, you won’t get that loan amount. The lender will base your loan amount on the $200,000 value, giving you 95% of that amount. This would leave you with quite a hefty down payment, which you obviously shouldn’t pay since you don’t want to pay more than the home is worth.
In addition to the appraiser’s protection, you also have the arm’s length principle of transfer pricing. This requires sellers to charge the same price for their home to a family member/friend as they would a stranger. This prevents the seller from inflating the price if selling to someone close to them, knowing that the buyer would likely trust them and pay the inflated price (assuming the loan went through).
As a non-arm’s length transaction, you’ll also be under closer scrutiny by the IRS. They will want to make sure that you are not buying the home for a much cheaper price than the home is worth. If you were to turn around after a year or two and sell the home for a great profit, you could be subjected to capital gains taxes, which could seriously take away from your profits.
If you decide to get involved with a non-arm’s length transaction, make sure it’s a transaction that is honest. You should also have plenty of representation between your lender and your lawyer. You can even involve a real estate agent to make sure there is plenty of unbiased support in the process in order to protect both sides of the transaction.Click to See the Latest Mortgage Rates»