‍A Non-Arm's Length Transaction

There are two categories in real estate transactions: arm's length and non-arm's length. Most people buy homes without knowing the seller personally or professionally. They're entirely acting in their self-interest. This is called an arm's length transaction. Essentially, when you purchase a home from a stranger. When the buyer and seller know each other, it's called a non-arm's length transaction. This type of relationship could be neighbors, co-workers, friends, and obviously, family.  

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Financial Misfeasance

When the buyer and seller know each other, they can better execute how the transaction would benefit them or possibly fraud. Perhaps they agree to deceive lenders so that they both end up profiting. The real estate market depends on the competition in arm's length transactions to coordinate prices. It craves the opposition of buyer and seller, supply and demand, or consumers and producers. In a non-arm's length transaction, one party may take advantage of another party. An unsuspecting family member may not question the price of a home from an untrustworthy relative. They often don't have a real estate agent working with them to tell them otherwise and then pay way more than the house's market value. 

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Lenders' Regulatory Obligations

Government and individual lender guidelines must be followed as protection. Lenders must do an in-depth investigation when checking your finances as a way to protect themselves from any illegal activity.

In a short sale, the price of the property is less than the amount of the total mortgage owed. Therefore, an arm's-length affidavit may be required by the lender. This protects against fraud from the seller, who may give the property to a family member who resides in the home after a short sale, allowing for a much cheaper mortgage rate. The affidavit states that no existing or prior association exists between the buyer and seller, and any violation of that could cause civil and criminal liabilities for everyone involved.

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Increasing Restrictions 

There are already many requirements to fulfill when applying for a mortgage in an arm's length transaction. That said, you will have even more to do in a non-arm's length If you are an employee of a builder (cannot be family), and you're purchasing a primary residence that is one of the builder's new houses or models

Purchase of a primary residence of a family member OR property owned by family member AND borrower has leased it legally for 6 months. A seller may have to verify to the mortgage lender that they're not delinquent on the current mortgage, therefore, requiring you to put down a down payment. For instance, if you want an FHA loan in a non-arm's length affidavit, your down payment has to be 15% of the purchase price, at least. Some exceptions allow for a down payment to be 3.5 %.

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More Taxes

More taxes may be involved if you are given a gift of equity. A gift of equity is when a family member or friend from which you're purchasing a home gives you a financial break. According to Internal Revenue Service laws, a family member can give up to $15,000/year to another family member or $30,000 for a married couple. Anything over that becomes taxable income for the seller. If you buy a house and then sell it a few years later for more, you, as the buyer, will be responsible for capital gains taxes as well. As always, it's best to contact an accountant or tax preparer to understand your potential tax liability.