What is an arm’s length transaction?

In real estate, an arm’s length transaction refers to situations in which there is a transfer of property and the buyer and seller act independently of one another. This kind of transaction ensures that both parties act in their self-interest to get the best deal, and that neither party exerts pressure over the other. 

Because the independent parties are acting in their self-interest, you can assume that the seller is pushing for the highest possible sale price while the buyer is bargaining for the lowest. This relationship ensures that properties are priced at fair market value, or the price that the property would sell for on the open market. It also assumes that both parties involved have equal access to information to guarantee fair negotiations.

In arm’s length transactions, you can expect that buyers and sellers have no pre-existing relationship. A personal connection could hinder a transaction from taking place at arm’s length, and therefore jeopardize the fair market value of the property. In this situation, one party may be willing to buy or sell the property for a price lower than what it would get at market value to benefit the other party. 

On a larger scale, dealing at arm’s length encourages fair business practices among real estate buyers and sellers, and protects the public from inaccurate pricing in the market.

Sales made not at arm’s length, also called arm-in-arm transactions, typically take place between family members, friends, or other parties with existing personal relationships. 

For instance, a mother is in the market to sell her home. After getting her home appraised, the fair market value of the home is determined to be $450,000. It turns out that her daughter is in the market to buy a home, and she is interested in the property. Unfortunately, the daughter is only able to pay $375,000. 

The mother might feel motivated to sell the home to her daughter despite the low cost even though she could make more money by taking the house to market and selling to a neutral party.

In real estate transactions, tax laws are set up to ensure that sellers pay a fair tax price despite accepting a lower offer. 

Sellers are required to pay taxes on how much they made from the sale of the investment property. In an arm’s length transaction, the seller would be required to pay taxes on the sale of the home as if they had sold to a neutral party at fair market value rather than at a discounted price. 

In the example above, the mother would have to pay taxes on the fair market value of the home, or $450,000, rather than the price that she accepted, which was $375,000. 

When a buyer and seller act independently and in their self-interest, this ensures that the price of the property for sale is an accurate representation of what a neutral seller would be willing to accept for the property, as well as what a neutral buyer would be willing to pay for it. This dynamic determines the fair market value of a property.

According to real estate marketplace Opendoor, home value is determined by: 

1. Neighborhood comps

2. Location

3. Home size and usable space

4. Age and condition

5. Upgrades and updates

6. The local market

7. Economic indicators

8. Interest rates

The first determinant—neighborhood comps—takes into account the cost of recently sold comparable properties in the area. When a buyer and seller conduct a non-arm’s length transaction, this could potentially impact the cost of other houses in the area. An arm’s length transaction, in relation to other transactions in the area, sets the precedent for how much a property with similar characteristics is likely to be sold for in a certain area or market. 

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