You found your dream home and can’t wait to get financing for it. There’s one problem. The seller happens to be an immediate relative. While you may not see a problem with it, lenders have an issue. The arm’s length transaction just became a non-arm’s length transaction and lenders care about these issues.
What is a Non-Arm’s Length Transaction?
A non-arm’s length transaction occurs when you buy a home from someone close to you. The relationship could be professional or personal. You don’t have to be directly related. If you buy a home from your best friend or your boss, it’s a non-arm’s length transaction.
What is an Arm’s Length Transaction?
An arm’s length transaction occurs when you buy a home from a virtual stranger. You don’t have any type of pre-existing relationship with the seller. Both the buyer and the seller in an arm’s length transaction can operate independently of one another. In other words, neither the buyer or the seller is subject to any type of pressure from the other side.
Why Does it Matter?
Non-arm’s length transactions create several issues:
- The risk of loan default becomes higher
- The risk of fraud is present
- The home may sell for less than its actual market value
Lenders put themselves at risk of default in non-arm’s length transactions. Most lenders really scrutinize these types of transactions to make sure they are following the rules. The home’s value is of largest concern. Obviously, an appraisal will catch an inflated sales price the moment he values the home. But an under-valued home poses tax issues. In fact, the IRS often treats non-arm’s length transactions a little differently. They typically tax the seller on the market value of the home rather than the sales price.
Short Sales and Non-Arm’s Length Transactions
Put simply, lenders don’t allow non-arm’s length transactions on short sales. Lenders typically require a signed affidavit stating that there isn’t a relationship between the buyer and seller. This helps reduce the risk of any special ‘deals’ between the parties that aren’t noted in the contract. The affidavit is a legal document, so make sure you are honest when completing it.
The affidavit also covers the real estate agent, any compensation the buyer or seller may receive from the transaction, and it prohibits the seller from living in the property again after closing. In other words, the seller can’t short sale the property to a relative and then take up residence in the home again after the closing.
Non-arm’s length transactions are hard to get through financing. It’s best to avoid them if at all possible. If you do want to buy a home from a relative or someone else you have a close relationship with, be upfront with the lender right away. They can guide you through the process and choose the most appropriate loan program that will allow the situation.