Understanding Arm’s Length Transactions

Arms length transactions are important to understand in commercial real estate, particularly for lenders. To see why consider the following scenario. Suppose you’re the lender to an LLC formed to acquire an office building. However, after closing the loan you discover that the LLC’s managing member is the brother of the seller. It turns out the brothers conspired to transfer the office property at an inflated price. Months later, the borrower defaults and the brothers disappear.

Now you’ve foreclosed on an office that is worth less than the outstanding loan amount. Might have been nice to know the seller and buyer were related and this was not an arm’s length transaction.

Or consider another scenario. Suppose you own several rental properties and then decide to sell them to your son at a market rate. But then later you get a call from your accountant explaining that the gain you made on the sale would be treated as ordinary income instead of a capital gain, and your ability to use a like-kind exchange would be restricted.

Again, might have been nice to know that agreements between certain related parties could have significant tax implications.

These are two examples of non-arm’s length transactions, and a good illustration of why it’s important to understand the concept of an arm’s length transaction. In this article we’ll discuss:

  • What makes a transaction arm’s length, and why people care
  • What types of relationships may cause an entity to characterize the transaction as non-arm’s length
  • Examples of when non-arm’s length transactions are either subject to increased scrutiny, special treatment or disqualification
  • How third parties can protect against the risks of non-arm’s length transactions, and
  • Some of the common frauds used by related parties, and their consequences

What is an Arm’s Length Transaction?

When a third party looks at a commercial real estate transaction, it wants to know if the value ascribed to the property under the agreement represents a fair market value. One can be relatively sure of this if the transaction was done at arm’s length, meaning (1) the parties are unrelated (whether in the familial or business sense), (2) they have equal bargaining power, and (3) they are acting in their own self-interest. The seller seeks the highest price, the buyer seeks the lowest price, and market value results.

Where these conditions exist, third parties can generally assume the sales price wasn’t clouded by one party controlling the other, or by collusion between the parties.

In contrast, a non-arm’s length transaction occurs where parties are related to such a degree that their independence is called into question. Where these relationships exist there is a greater likelihood that one party leveraged power over the other, either controlling or influencing their actions, or that the parties acted together, to manipulate the sales price. In short, there is a risk that they didn’t act independently of each other.

So is a non-arm’s length transaction illegal? On its own, no.

In the father-to-son example above, it was clearly a non-arm’s length transaction because of the familial relationship. But, while this relationship may increase the risk for price manipulation, and may thus incur scrutiny from third parties, disqualify it from participating in certain lending programs, or result in certain tax consequences, there is nothing unlawful about a father selling property to his son. There was no price manipulation, no intent to defraud a third party.

Of course, if the related parties (like in the brothers example above) colluded to manipulate the sales price for the purpose of defrauding the lender and obtaining a larger loan, well then, yes, the FBI may care about that one.

The point is that the relationship qualifies a transaction as arm’s length or not. Third parties can decide how they’ll treat the transaction if it is not arm’s length, but non-arm’s length alone is not unlawful.

One caveat to the above: Third parties may define for themselves what qualifies as an arm’s length transaction. This is sensible given that the purpose of this concept is in large part to protect third parties from the risk of manipulated values. Who better to determine that risk than the person taking it? For example, U.S. Department of Housing and Urban Development (HUD) defines an arm’s length transaction as one that meets market value. Period. They don’t care who the parties are. They go right to the finish line. Fair market value? Okay. We’re good.

What Types of Relationships are Deemed Non-Arm’s Length?

While there is no universal list of relationships that result in a non-arm’s length transaction, there are common denominators. Such relationships have either an imbalance of power (e.g., one party has control over the other) or an increased likelihood of collusion, and these increase the risk that parties may manipulate sales prices or conceal important facts about the transaction.

That being said, the following are some of the more commonly qualifying non-arm’s length relationships:

  • Family members (e.g., child (including stepchildren), parent, grandparent, spouse, legally adopted children, and foster children)
  • Parent companies and its subsidiaries or affiliates
  • Principal owners of an entity, and their family members
  • Management of an entity, and their family members
  • Guardians and wards
  • The trustee and beneficiary of a trust, and
  • Employers and employees

Now, generally where parties fall into one of these categories, they’ll be subject to the third party’s non-arm’s length transaction rules (e.g., don’t qualify for a loan on a short sale). However, third parties may also allow entities to show that the risk attendant to their relationship is not present. This can be as simple as (1) providing independent verification that the sales price is close to fair market value, and (2) filing an affidavit stating that the parties are acting in their own self-interest, are on equal footing, and that no collusion, influence or duress occurred.

Examples of Non-Arm’s Length Transactions Subject to Special Consequences

Internal Revenue Service. You should consult with a tax professional on the intricacies of the IRS’s special treatment of property transfers between related parties. For here though, we’ll just note that these transfers can have significant tax impacts, including, for example, treating capital gains as ordinary income, restricting the use of like-kind exchanges, and characterizing sales as gifts.

Lenders. Especially aware of the risk and cost of mortgage fraud, some banks completely prohibit loans on property for a short sale between relatives. Even short sales between unrelated parties can come under special scrutiny, e.g., lenders often require an affidavit of arm’s length transaction stating that the parties are unrelated, and acting their own best interest.

Federal Housing Administration (FHA). With some exceptions, the FHA requires a 15% equity position for non-arm’s length transactions (i.e., between family members, business partners or other business affiliates). In the case of short sales, the FHA requires that the parties be unrelated. The FHA also utilizes an Identity of Interest Certification where borrowers disclose, among other things, their relationship to the seller.

Veterans Administration (VA). In certain circumstances, the VA will not loan funds for a non-arm’s length transaction, including, for example, “construction-to-permanent financing” (where a veteran seeks a long-term mortgage to replace the interim financing she used to fund construction of the home).

Fannie Mae. With some exceptions, Fannie Mae will allow non-arm’s length purchases, but has different requirements for existing properties vs. newly constructed properties. In short sales, Fannie Mae will require an Affidavit of Arm’s-Length Transactions to confirm that the parties are unrelated, and that no other contracts exist for the property (e.g., resale contracts).

Freddie Mac. Freddie Mac allows for short sales, but only to unrelated parties. As with Fannie Mae, Freddie Mac uses an Arm’s Length Affidavit to confirm there is no relation.

Due Diligence Methods to Determine if Transaction is Arm’s Length

Because of the risk and cost of mortgage fraud committed by related parties, lenders will require the parties to provide a host of items to verify the transaction is arm’s length. The following are common requirements:

  • Provide a copy of the contract between buyer and seller
  • Provide an independent appraisal of property
  • Provide an affidavit of arm’s length transaction disclosing the parties’ relationship
  • Where the parties are related, but the purchase price is close to market value, have a third party compare the contract terms with those of a similar transaction, but with unrelated parties

Common Fraudulent Schemes by Related Parties – Property Flip and Short Sale

Property flipping involves buying property and then reselling it quickly for a profit. Typically the increased sale price is a result of improvements made by the flipper. The practice of flipping in and of itself is of course lawful. However, as Freddie Mac explains, where the increase in sales price is fraudulent, the act becomes a crime:

Property flipping becomes illegal and a fraud for profit scheme when a home is purchased and resold within a short time frame at an artificially inflated value. The flip typically involves a fraudulent appraisal, which may indicate that renovations were made to the home, when, in fact, there were none, or the renovations consisted only of minor cosmetic improvements.

The harm caused by this scheme is largely to the lender. As first described in the brothers example above, a fraudulently inflated valuation can lead to a lender owning property worth far less than the money it was owed.

A short sale occurs where a property is sold, and the lien holder receives less money from the sale proceeds than is owed by the seller. Banks may approve a short sale where it believes the cost of foreclosing, and then reselling, the property would be more expensive than accepting the loss on the loan repayment. As with property flips, a short sale can be legitimate, but may also be a part of a mortgage fraud scheme. For a more in-depth look at common types of types of fraudulent short sale schemes you can take a look at Freddie Mac’s summary here. The common theme of these schemes is that the bank approving the short sale is somehow deceived when it agreed to accept less money than it was owed.

For a good discussion of different types of mortgage fraud, and ways to protect against them, see this white paper by the Federal Financial Institutions Examination Council

So, what are the consequences of these related party schemes? Well, state mortgage fraud crimes and federal mortgage fraud crimes (where federal agencies were involved, e.g., FHA, where federally regulated financial institutions were involved, or where actions related to the fraud crossed state lines). Federal prosecution can even involve RICO (Racketeer Influenced and Corrupt Organizations Act) charges if the fraud is large enough.

If convicted of mortgage fraud, parties can face significant fines, may be forced to make restitution, and even serve time in prison. State fines, restitution and prison sentences vary, but federal convictions can mean 30-year prison sentences, $1M fines for each count of fraud, and restitution to those parties injured by the fraud.

Conclusion

So, who cares whether a transaction is arm’s length or not? If you’re a lender, you probably raised your hand when you read the question, but for the rest of the professionals in the real estate world, hopefully this article helped you understand why lenders care, why lenders scrutinize related-party transactions, and why lenders ask for so many affidavits.

Oh, and if you were considering partnering with a cohort to commit a related-party mortgage fraud scheme, hopefully this last section helped you understand that you should care too. And convinced you not to commit fraud. As always, because this article is only for informational purposes, and not to give legal advice, if you have any particular arm’s length issues, please consult a licensed attorney.

Have you ever come across an undisclosed related-parties transaction? Negotiated with a bank to get arm’s length treatment? Let us know in the comments below (or, of course, ask any questions you may have)!