Non-Arm’s Length Transactions
A non-arm’s length transaction occurs when a buyer and a seller have an existing relationship. This impacts taxation and valuation.
Non-Arm’s Length Transactions
A non-arm’s length sale — often called an arm-in-arm sale — is a transaction in which the buyer and seller have an established relationship. Outside of commercial real estate, these types of deals generally include a family member selling a house to another, or someone selling a car to a friend.
In commercial real estate, parties engaging in a non-arm’s length transaction could include two subsidiaries of a company transferring ownership of real estate, or even simply transferring real estate from one legal entity to another, even if the exchange is within the same organization. Other non-arm’s length sales could include executives buying or selling real estate from their companies.
Heavy Scrutiny
Non-arm’s length sales are heavily scrutinized because of the potential for fraud. For example, an investor could “sell” an asset from one legal entity it controls to another at a high markup, looking to obtain more funding than a market-based transaction’s LTV would allow for. This, however, is typically classified as mortgage fraud and could result in civil or criminal penalties.
Even without black-and-white examples of illegal activities, other issues may exist with arm-in-arm deals. For example, a buyer could pressure a seller in accepting an artificially low price — or vice versa — leveraging the existing relationship. As a result, tax authorities and lenders must review such deals closely.
How Are Non-Arm’s Length Deals Taxed?
Real estate transfer taxes are typically based on a property’s full market value. In an arm’s length deal, the market value is generally the actual sale price. However, with a non-arm’s length sale, this doesn’t hold true — and so typically tax authorities use a property’s full market value. Note that this is not as simple as using the value your county’s property assessor has determined, as this data often has a lag of one to two years.
Tax Example
Consider this example of a non-arm’s length sale and its tax implications. Company A sells a small, 10,000-square-foot Class B industrial building to its subsidiary, Company B, in a county where the transfer tax is 1% of a property’s value. The actual sale price is $25,000, due to the relationship between the two parties.
However, Company A can’t simply pay $250 ($25,000 x 1%) to the county government, as this is not based on the building’s full market value. Let’s say that, based on historical property assessments and recent market performance, the building’s full market value at the time of the sale is $3 million. The calculation would be based off of this value instead, resulting in a significantly higher tax bill of $30,000.
Related Questions
What is a non-arm's length transaction?
A non-arm's length transaction is when the buyer of a product has a preexisting familial or business relationship with the seller. For instance, if an investor were to sell their sibling an apartment building, the transaction would not be arm’s length. This has important consequences when it comes to buying and selling commercial real estate, as lenders may be wary of working with borrowers who are purchasing a commercial property from a relative or business partner. Non-arm's length transactions can also have significant tax implications, such as one party purchasing a property from another party at a significant discount, but still needing to pay property taxes on the full market value of the property. Additionally, attempting to engage in a 1031 exchange with a related party is often more trouble than it’s worth, as the IRS has instituted additional rules involving related-party transactions in order to reduce the potential for tax avoidance.
What are the risks associated with non-arm's length transactions?
Non-arm's length transactions can involve ethical issues, such as an employee of a company being threatened with termination or otherwise coerced into purchasing a piece of real estate for (or from) their employer. Additionally, there are tax implications to consider, such as the need to pay property taxes on the full market value of the property, even if it was purchased at a discount from a relative or business partner. Attempting to engage in a 1031 exchange with a related party is often more trouble than it’s worth, as the IRS has instituted additional rules involving related-party transactions in order to reduce the potential for tax avoidance.
What are the benefits of non-arm's length transactions?
Non-arm's length transactions can provide a number of benefits, such as the ability to purchase a property at a discount from a relative or business partner. Additionally, a 1031 exchange with a related party can be beneficial, as it allows for the deferral of capital gains taxes. However, it is important to understand the potential tax implications of such transactions, as the IRS has instituted additional rules involving related-party transactions in order to reduce the potential for tax avoidance.
For more information, please see Arm's Length Transactions in Commercial Real Estate.
What are the legal implications of non-arm's length transactions?
In many cases, a non-arm’s length transaction will involve one party purchasing a property from another party, sometimes at a significant discount. However, they will still generally need to pay property taxes on the full market value of the property. This is essential to understand if you are considering buying commercial real estate at a discount from a relative or business partner. In addition, attempting to engage in a 1031 exchange with a related party is often more trouble than it’s worth, as the IRS has instituted additional rules involving related-party transactions in order to reduce the potential for tax avoidance.
In addition to a borrower “paying themselves” with renovation loan proceeds, or having a family member buy a property during a short sale, other ethical issues can arise from non-arm’s length transactions, specifically, issues between supervisors and employees. For instance, an employee of a company could be threatened with termination or otherwise coerced into purchasing a piece of real estate for (or from) their employer. This is yet another reason why many lenders tend to dislike deals in which the borrower and another party have an identity of interest.
How can non-arm's length transactions be avoided?
The best way to avoid non-arm's length transactions is to ensure that the buyer and seller of a commercial property do not have a preexisting familial or business relationship. This means that the buyer and seller should not be related, and should not have any other type of relationship that could influence the transaction. Additionally, lenders may be wary of working with borrowers who are purchasing a commercial property from a relative or business partner, so it is important to be aware of this when considering a loan product.
For more information, please see Arm's Length Transactions in Commercial Real Estate.
What are the tax implications of non-arm's length transactions?
In many cases, a non-arm’s length transaction will involve one party purchasing a property from another party, sometimes at a significant discount. However, they will still generally need to pay property taxes on the full market value of the property. This is essential to understand if you are considering buying commercial real estate at a discount from a relative or business partner. In addition, attempting to engage in a 1031 exchange with a related party is often more trouble than it’s worth, as the IRS has instituted additional rules involving related-party transactions in order to reduce the potential for tax avoidance.