A non-arm’s length transaction occurs when two parties involved in a deal have a prior relationship, such as family ties, close friendship, or business connections, which influences the transaction terms. Unlike an arm’s length transaction—where both parties act independently and negotiate based on fair market value—non-arm’s length transactions may feature prices or conditions that favor one side due to their relationship.
Arm’s Length vs. Non-Arm’s Length Transactions
For example, buying a car from a stranger typically reflects the vehicle’s true market price since neither party has a vested personal interest in the other’s outcome. This is an arm’s length transaction. Conversely, buying the same car from a relative at a discounted price because of family ties illustrates a non-arm’s length transaction.
| Feature | Arm’s Length Transaction | Non-Arm’s Length Transaction |
|---|---|---|
| Relationship | Independent, unrelated parties | Related parties (family, business partners) |
| Motivation | Each party maximizes own benefit | Relationship influences terms |
| Price | Typically matches fair market value (FMV) | May be above or below FMV |
| Scrutiny | Generally limited | High scrutiny by IRS, lenders, and courts |
Common Situations Involving Non-Arm’s Length Transactions
- Selling property below market value to family: A parent sells a home to their child at a steep discount.
- Loans among friends or relatives: Loans granted with non-standard terms, such as no interest or flexible repayment.
- Intercompany asset sales: Parent companies transferring assets to subsidiaries at non-market prices to shift profits.
- Renting property to relatives: Charging below-market rent to family members.
Why Are These Transactions Closely Monitored?
Non-arm’s length deals can facilitate tax avoidance or fraud. For example, the IRS disallows loss deductions on sales of property between related parties to prevent artificial tax losses (IRC Section 267). Additionally, underpricing property sales to family members can trigger federal gift tax obligations if the discount exceeds the annual exclusion amount ($18,000 for 2024). The IRS requires filing Form 709 for such gifts, though tax may be deferred using lifetime exemptions (more on Form 709).
Lenders scrutinize these transactions because property purchased below or above market value can distort loan risk assessments, potentially resulting in mortgage fraud or inflated loan amounts. Lenders often demand independent appraisals and extensive documentation for transactions flagged as non-arm’s length (mortgage qualification criteria).
Tips for Managing Non-Arm’s Length Transactions
- Get an independent appraisal. Obtaining an unbiased valuation helps verify the asset’s fair market value.
- Document everything. Formal written agreements clarify terms and demonstrate professionalism.
- Consult professionals. Talk to a CPA about tax consequences and a financial advisor or attorney about legal matters.
- Be transparent with lenders. Disclose any related-party nature of the transaction upfront.
Frequently Asked Questions
Are non-arm’s length transactions legal?
Yes. These deals are legal if conducted transparently and comply with tax and legal standards.
Can I get a mortgage when buying from family?
Yes, but expect extra verification, including an appraisal and supporting documentation, since lenders scrutinize these sales closely.
How does gift tax apply if I sell property below market value?
The IRS treats the difference between sale price and fair market value as a gift. The 2024 annual gift exclusion is $18,000 per person. Amounts exceeding this require filing Form 709 (Form 709 details). Taxes are typically deferred by applying lifetime exemptions.
For more details on related party transaction rules, visit IRS resources on related party transactions and guidelines in Internal Revenue Code Section 267.
Sources:
- IRS Publication on Related Party Transactions (IRS Topic No. 502)
- IRS Gift Tax FAQs (irs.gov)
- Form 709 Glossary at FinHelp.io
- Mortgage Qualification Criteria at FinHelp.io
This article is designed to help you understand the key aspects and implications of non-arm’s length transactions in U.S. financial and tax contexts.