What Is an Arm's Length Transaction?

What Is an Arm's Length Transaction?

Let me explain what an arm's length transaction is: it's a business deal where the parties involved act voluntarily and independently from each other.

In these transactions, you see all parties pursuing their own self-interest without any pressure from others, which prevents collusion between buyer and seller. For fairness, both sides typically have equal access to deal-related information.

Key Takeaways

You should know that an arm's length transaction involves unrelated parties acting solely in their self-interest, with no affiliations between them. These deals in real estate help properties get priced at fair market value. They also affect financing and taxes. Remember, deals between family or companies with related shareholders aren't arm's length.

Understanding Arm's Length Transactions

Arm's length transactions are common in real estate because the sale impacts not just the direct parties but others like lenders too.

If two strangers buy and sell a house, the agreed price likely matches fair market value, assuming equal bargaining power and shared property info. The seller aims for the highest price, the buyer for the lowest, so the final price shouldn't stray from actual fair market value.

Beyond buyer and seller, these transactions influence bank financing, municipal taxes, and even market comparables.

Arm's Length vs. Non-Arm's Length Transactions

Family members or companies with related shareholders usually don't do arm's length sales; those are non-arm's length instead.

A non-arm's length transaction, or arm-in-arm deal, happens when buyers and sellers share an identity of interest, like a business or personal relationship.

Such relationships often skew the terms—for example, a father might discount a sale to his son, unlike dealing with a stranger.

If taxable, authorities might make the seller pay taxes on the gain from a neutral third-party sale, ignoring the actual price. Similarly, international sales between related companies must use arm's length prices via transfer pricing to ensure each country gets proper taxes.

Important Note on Tax Laws

Tax laws worldwide treat transactions differently based on whether parties deal at arm's length or not.

Arm's Length Transactions and Fair Market Value (FMV)

One key benefit of arm's length transactions is their fairness, especially in real estate, where no prior relationship means the sale price reflects true market conditions like FMV.

FMV is the optimal price an unrelated, neutral seller and buyer agree on to close the deal. Factors determining a home's FMV include location, comparable prices, condition and age, size and amenities, renovations, plus broader elements like interest rates and economy.

Example of an Arm's Length Transaction

Consider this hypothetical: John sells his home for $350,000, getting an offer at that FMV based on location, amenities, and comparables. If he accepts from a stranger, it's arm's length.

But if his son Henry offers $275,000 for a family discount and John accepts, it becomes non-arm's length.

What Is the Difference Between an Arm’s Length Transaction and Other Sales?

An arm’s length transaction occurs between independent, unassociated parties outside the deal itself. In contrast, it's not arm’s length if buyer and seller are related, like family, friends, or a parent company and subsidiary.

Why Are Arm’s Length Transactions Important?

Whether a transaction is arm’s length matters for legal and tax reasons. For multinationals, transactions with affiliates must use fair market values for correct taxes per jurisdiction.

Conglomerates risk legal issues if internal companies don't transact at arm’s length. Overall, these transactions promote fair practices and protect the public.

What Are Some Examples of Non-Arm’s Length Transactions?

Think of a mother selling her car to her son at a discount, even though she could get more from a stranger—that's non-arm's length due to family ties.

While benign, harm can occur, like a public company founder appointing a less qualified family member to a key role, hurting shareholders.

The Bottom Line

Every buyer and seller seeks the best price in transactions, and arm's length deals achieve that without relationship biases affecting price or decisions.

Non-arm's length ones might not yield the best price, impacting markets and lending.