A type of agreement or transaction in which both parties involved are of equal standing.
Details of Arm's Length
Arm's length transactions are common transactions in real estate. During the sale of a house, the price typically settles around market value. This is because the seller and the buyer are looking to agree on a price that benefits them. This means that the seller would like a high selling price, and the buyer would look for a low selling price. What they agree upon is typically in the middle. This then creates a transaction between two strangers that allows each party to have equal grounds for gain in the matter.
Example of Arm's Length Transaction
Joe decided to sell his house. He hired a realtor, who then listed that house on the company real estate site. Once the realtor had sufficient interest in the property, they held a showing. The showing quickly caught the attention of several buyers. Joe's son Simon loved the property and was also interested in purchasing it. Joe, however, needed to make a substantial profit on the property. Simon believed that he could purchase the property at a lower cost because he is Joe's son.
Jane came to the showing and put in an offer close to the asking price of the house. Simon also put in an offer on the house for a lower value. Joe knew that he would have a better sale, and better tax rates if he sold to a new and independent party. Joe accepted Jane's offer on the house.
Because Jane was not involved in Joe's life, she was able to get a mortgage that was in her favor, and the taxes she paid on the property were in line with the price of sale. Joe was able to make a profit on his house because he chose to sell to a stranger. This sale put both Joe and Jane on a level playing field, as there was no personal interest in anything but a fair and equal sale.
Significance of Arm's Length
Arm's length transactions are important for many legal reasons. When two parties engage in a sale of property, taxes can easily influence the sale. When a sale occurs between two parties acting independently, there is more incentive to reach a conclusion that benefits both parties.
In a sale that has personal ties, neither party is entering a sale equally. One party is therefore in a position of power. In many cases, properties are not sold at an arm's length; the buyer has an advantage. This typically happens when a family member sells a piece of property to another family member.
When a property is sold to a family member, the sale price is less than fair market value. When someone sells a property below market value to a person with a personal stake, many tax agencies will require the seller to pay taxes on the property's market value rather than the sale price. This is because they are making a conscious choice to short the value of the sale.