What is an Arm’s Length Transaction?

An arm’s length transaction is a business deal where the buyers and sellers act independently. Neither party influences the other. Normally, the parties will have no pre-existing relationship, and both parties will have equal access to information relating to the deal.

Arm’s length transactions are typically used in real estate deals. This is because the sale doesn’t just affect those involved in the deal; it affects other parties too (typically lenders).

Understanding arm’s length transactions in real estate

In a property sale, the final price of the property is likely to accurately reflect the fair market value, assuming both parties have no existing relationship and both have equal information about the property.

Both parties act with their own best interests in mind: the seller wants the most possible money for the property, and the buyer wants to pay the least possible money.

Why are arm’s length transactions a good thing?

Arm’s length transactions help to encourage fair and reasonable business practices. They also make it easier for other (non-involved) parties to use the results as a benchmark.

For instance, if a house just like yours on your street sells for $300,000, you might expect your own house to sell for a similar amount. However, if the $300,000 was a generous price paid by one friend to another, then it may not reflect fair market value

What’s a non-arm’s length transaction?

A non-arm’s length transaction, also known as an arm-in-arm transaction, is the opposite of an arm’s length transaction. This is where two parties in an existing relationship (either a personal or a business relationship) come to a deal. For instance, if a parent sells a house or a car to their child, this is a non-arm’s length transaction: the parent would likely offer the child a discount.

Non-arm’s length transactions are legal, but tax laws are generally designed to treat these transactions differently from arm’s length transactions.

For example, if you make an international sale between two subsidiaries of the same parent company, this should be made using arm’s length (neutral) prices. This is transfer pricing, and it ensures each country gets its fair share of taxes.