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How to Finance a Non-Arm’s Length Transaction

It’s quite possible you’ve heard of this term but not truly understand what it means. But to understand its meaning perhaps it’s easier to first get clear on what a non-arm’s length transaction is. It’s a figurative term which means any deal made must be at arm’s length as it relates to negotiations. It’s a transaction where both parties, in the case of real estate the buyer and the seller, are negotiating independently and have no familial relationship with one another. Further, all parties in a real estate deal must also not have any formal or business relationship. This ensures there is no favoritism the seller shows when establishing a sales price.

For example, let’s say a mother decides to sell her home to her daughter and move into a smaller home for retirement. Because she’s her daughter, it’s very likely the sales price would be very, very attractive and not a price what an anonymous buyer would get. Instead of the mom working in her daughter’s best interest by lowering the sales price, an arm’s length transaction would mean the mom would deal in her own best interest and ask for the highest price possible. A non-arm’s length transaction might be evidence of a conflict of interest. In such transactions, it’s more difficult to establish the true market value of the home. Further, there could be such a differential between a true market price and the cozy deal the difference is viewed as a gift.

Establishing Value

When two parties sign a sales contract on a home, it is assumed the final sales price is where the most the buyer is willing to pay meets with the least the seller is willing to accept. All things being equal of course and there is no outside influence that might force a seller to accept a below market offer. For example, the seller might be in some stage of foreclosure and needs to close fast or a couple is getting divorced and the home is priced well below market in order to get rid of the jointly owned home and the mortgage that goes along with it.

A mortgage lender who accepts a loan application accompanied by a sales contract the lender orders an appraisal. The appraiser then is charged to validate the sales price listed on the contract. This is done by comparing recent home sales of similar properties in the neighborhood of the subject property. Various adjustments are taken into consideration such as one home having a view of the mountains or is located on a cul-de-sac compared to a home right on a very busy street.

Once the value is established, the report is returned to the lender. The lender then uses the lower of the sales price or appraised value when establishing loan terms. Even if the sales price of the home were $350,000 and the appraisal came in at $325,000 the lender would use $325,000 as the value. The buyers would then have to decide if they want to come up with the additional $25,000 or walk from the deal entirely. It’s through an independent evaluation with actual data of recorded sales that make for a proper appraisal.

However, if the deal might be considered as “non-arm’s length” the value might very well be skewed. Consider these statements-

  • “You won’t believe what my brother just sold his property to me for!”
  • “My boss is letting me buy one of her homes at a ridiculous price.”
  • “I practically stole this home from my dad, he sold it to me for $50,000 less than what his agent had it listed for!”

Any of these statements gives a clear indication the deal was not made at arm’s length. This isn’t to say that a non-arm’s length purchase is completely dead in its tracks, it’s just there will be additional requirements made in order for the loan application to be approved. And to complicate the issue further, if indeed you bought a home that was $50,000 below market value if the IRS ever saw that it could be considered income beyond the annual gift-giving limits. There is a form called an Identity of Interest questionnaire that literally asks what the relationship is between you and the seller.

Mortgage companies who offer financing for a non-arm’s length purchase may have additional requirements. One such requirement may be to verify the seller is not currently delinquent on the existing mortgage which would indicate a distressed sale, for example.

How to Finance Non-Arm’s Length Transaction

The Non-Arm’s Length Option

Beyond all that, there are ways to finance a non-arm’s length purchase. One of the ways is to finance the purchase using an FHA loan. The maximum FHA loan amount for San Diego County is currently $580,750 for a single family home, $743,450 for a duplex, $898,700 for a triplex and $1,116,850 for a four unit property. 2-4 unit homes are eligible for FHA financing as long as you occupy one of the units as your primary residence.

For a non-arm’s length FHA loan, you’ll be required to put at least 15 percent down compared with a minimum 3.5 percent down for an arms’ length purchase. Again, a non-arm’s length transaction isn’t a deal-killer but you will be asked for a larger down payment. Rates and fees for the non-arm’s length FHA program, however are not affected.

Conventional loans underwritten to Fannie Mae or Freddie Mac standards also allow for the financing of a non-arm’s length transaction but only for existing inventory and for a primary residence.

Mortgage loans that fund these purchases require more scrutiny than an arm’s length transaction but as long as the sales price of the home appears to be near current market value and an Identity Form is completed outlining the relationship between the buyer and seller, then financing is readily available.

Non-Arm’s Length Transactions & Conventional Loans

Conventional mortgage loans underwritten to standards issued by Fannie Mae and Freddie Mac also address a non-arm’s length transaction. Fannie and Freddie loans specifically address a non-arm’s length transaction and both make accommodation’s for them. Neither Fannie nor Freddie have any problem financing a property even with an existing non-arm’s length transaction as long as the borrower is approved using standard conventional guidelines, including establishing a fair market value concluded by a property appraisal.

However, both will not issue an approval with a verified non-arm’s length transaction if financing new construction, a second home or an investment property. Only a primary residence can be financed when there is a transaction is deemed non-arms’ length, other than that, the loan can be approved much like any other without any additional lender requirements referred to as an “overlay.” A lender overlay is an added loan requirement an individual lender can require that goes beyond conventional guidelines. For example, a lender might approve an investment property loan with borrower debt ratios of 50 and add an overlay of a credit score above 780.

Lender overlays are added to existing loan approval guidelines in an effort to shore up the quality of loans it approves. Overlays are perfectly legitimate as long as the overlay is applied uniformly and not on selected applicants. What a lender may not be able to do is ignore an existing guideline in order to approve a loan and still be able to sell such a loan in the secondary market.

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