Posted On: May 16, 2024

What Is an Arm's Length Transaction?

The home sale process in real estate can very quickly become confusing for everyone involved including the buyer, the seller, and the agents representing them. There are quite a few steps involved, as well as new terminology you’re probably hearing for the first time. One of these terms is an “arm’s length sale.”

In this blog, we will delve into the intricacies of an arm's length transaction, including its definition and why it’s important for you to know.

What Is an Arm’s Length Transaction in Real Estate?

An arm's length sale is defined as a transaction between unrelated parties who are each acting in his or her own best interest. This means that a transaction occurs between two parties who are unrelated and have no personal or financial relationship with each other. The term "arm's length" implies that the transaction is conducted as if the two parties have equal bargaining power and are acting independently.

Arm's length sales are often relied upon as a benchmark when evaluating property values and assessing market conditions. By comparing similar properties sold under arm's length conditions, they can determine a fair market value and make informed decisions regarding financing, taxation, and investment.

When Is an Arm’s Length Sale Required?

An arm's length sale is typically required in several specific situations to ensure fairness, transparency, and compliance with regulations. Here are some instances when an arm's length sale is necessary:

Tax assessments: For property tax purposes, an arm's length sale is required to determine a property's fair market value accurately. Arm's length transactions provide benchmarks for assessing property values and calculating taxes.
Mortgage Financing: Arm’s length transactions provide fair market value of a property when providing mortgage financing. The property value influences the loan amount, down payment, and interest rates offered to the borrower.
Legal Proceedings: An arm's length sale may be mandated in legal matters to ensure that the property is sold at its true market value without any influence or bias from involved parties, such as in divorce settlements.
Investment proceedings: In real estate investment deals, especially those involving partnerships, joint ventures, or syndications, an arm's length sale is necessary to protect the interests of all parties involved and to ensure fair dealings.
Government programs: Certain government programs and incentives may require arm's length sales to prevent abuse or manipulation of the benefits offered. This is common in programs like first-time homebuyer grants or affordable housing initiatives.
Insurance claims: In cases of property damage or loss, an arm's length sale may be necessary to determine the property's pre-incident value for insurance claim purposes.
Regulatory Compliance: Regulations in some jurisdictions require this transaction type to avoid conflicts of interest and ensure fair practices.

How Do Arm’s Length Sales Differ From Other Types of Real Estate Transactions?

The primary differences between arm’s length sales and others, such as court-ordered sales, are:

Relationship between parties: In an arm's length sale, the buyer and seller have no personal or financial relationship with each other. They are unrelated and act independently, without any pre-existing connections. This contrasts with non-arm's length transactions, where the parties may have a familial, business, or close personal relationship.
Independent relationship: The buyer and seller are unrelated and act without a personal or financial relationship.
Independence and fairness: Arm's length sales are conducted with the assumption that both parties are free from any undue influence or pressure. Other transactions may involve biases or preferences from existing relationships.
Market value determination: Arm's length sales are crucial in establishing the true market value of a property. Non-arm's length transactions may not reflect market conditions or an accurate representation of the property's value.
Regulatory and legal considerations: Various regulations and legal requirements may apply specifically to arm's length sales where they may not to other transaction types.
Professional standards: Real estate professionals adhere to ethical standards that often necessitate arm's length transactions. They are expected to act impartially and provide unbiased advice to their clients. Non-arm's length transactions may present conflicts of interest and compromise professional integrity.

Example of an Arm’s Length Sale vs. Non-arm’s Length Sale

Imagine there's a house for sale, and the seller's name is John, while the potential buyer is his daughter, Jane.

John decides to put the house on the market for $300,000, the fair price based on its value. Jane, interested in buying the house, looks at similar homes in the area and considers its location and features. If they both agree on the price of $300,000 and the sale happens, it's called an arm's length transaction. This is because they both acted independently, like regular buyers and sellers, with no special family relationship affecting the deal.

However, if Jane tells her dad that she wants to buy the house and offers a lower price, say $250,000, just because they are family, it becomes a non-arm's length transaction. In this case, the personal relationship influences the price, and the sale might not be fair to John, the seller.

Why Are Arm’s Length Transactions Important?

Arm’s length transactions help ensure fairness and transparency in property dealings. They play a vital role in determining the equitable market value of a product. This value is reached through mutual agreement between independent buyers and sellers, free from any external pressures or coercion.

This transaction type establishes a benchmark for determining the market value of a property independent of any external factors from any involved party. This independence is essential to avoid conflicts of interest, manipulation of prices, or fraudulent practices.

In an arm's length transaction, both the buyer and seller may initially have differing price expectations, but they must negotiate to reach a consensus that reflects the interests of both parties. In contrast, transactions involving closely connected parties might lead to one party compromising their position to accommodate the other's demands, potentially skewing the final price in favor of one individual.

Arm's length transactions can ensure fairness in other fields, such as in employment, guaranteeing that the employer evaluates candidates solely on their merits. This separation helps uphold fair business practices, ensuring that candidates are selected based on qualifications rather than personal connections.

Next Steps

At AgentCampus, our online pre-licensing course will cover everything you need to know to prepare you for your career as a real estate agent, and help you pass your state real estate licensing exam.

You can also sign up for an online real estate exam prep course for the state you want to practice in. Expand your knowledge and test readiness for the real estate licensing exam for your state by signing up today!