How To Buy A House From A Family Member In A Non-Arm’s Length Transaction
Kevin Graham8-minute read
October 26, 2023
Buying a house from a family member or friend can be a great option. You may already be familiar with the home, the closing process can be less complicated and you might get a good deal to boot.
But it also may not be that simple. There are several factors to consider before you officially buy a house from a parent, aunt, uncle or another family member or friend. Let’s take a look at those.
What Is A Non-Arm’s Length Transaction?
A non-arm’s length transaction occurs when the buyer and seller have a personal relationship. A deal between friends, family or co-workers is considered to be a non-arm’s length transaction. With these home sales, self-interest may not be the motivation, for instance, when parents sell their home to an adult child. When a boss sells an employee their property, that’s also considered a non-arm’s length transaction. When applying for an FHA loan, a non-arm’s length transaction is known as “identity of interest.”
See What You Qualify For
Congratulations! Based on the information you have provided, you are eligible to continue your home loan process online with Rocket Mortgage.
If a sign-in page does not automatically pop up in a new tab, click here
Arm's Length vs Non-Arm's Length Transactions
Real estate transactions fall into two categories: arm’s length and non-arm’s length. Arm’s length transactions are what most people engage in when they purchase a home. Arm’s length transactions occur when two parties who don’t have a professional or personal relationship participate in a real estate deal and each side acts in their own self-interest. Purchasing a home from a stranger counts as an arm’s length transaction.
Are Non-Arm’s Length Transactions Illegal?
Not necessarily, of course, but non-arm’s length transactions face more scrutiny than arm’s length transactions because there could be a higher chance of fraud when both sides have a relationship.
Opportunities For Financial Misconduct
Markets depend on the adversarial nature of the parties in arm’s length transactions to set prices: buyers versus sellers, supply versus demand or producers versus consumers. When parties have a familial or economic relationship, they might collude to defraud lenders or investors for their shared benefit.
It’s also possible that one party might manipulate the other party in some way – or both parties might try to cheat the fair market value price of the home. For example, the seller could inflate the price in hopes of pocketing more money from a trusting relative. The arm’s length principle of transfer pricing means that the sale price for the home has to be the same as if you were to undergo a deal between strangers.
Lenders’ Regulatory Obligations
Lenders have a responsibility to protect themselves, as well as the integrity of the mortgage lending market. As such, there are additional guidelines set by both lenders and the government for non-arm’s length transactions.
Additionally, law enforcement efforts to prevent the flow of ill-gotten gain have led to a regulatory framework where lenders must do their due diligence when it comes to the sources of your financial assets.
If a transaction is a short sale, the lender may require an arm’s length affidavit. A short sale occurs when a property is sold for less than the total amount owed on the mortgage. An arm’s length affidavit protects a lender against a type of mortgage fraud where borrowers who might sell or transfer their property back to a family member who stays in the home after the short sale with a greatly reduced mortgage amount. The affidavit states that there’s no prior relationship between the buyer and seller. Any violations may cause civil and/or criminal liabilities for the people involved.
Things To Know When Pursuing A Non-Arm’s Length Transaction
When family or friends are involved, some requirements for non-arm’s length transactions are put into place to protect each person involved. Other requirements protect the lender and sometimes, there are emotional aspects to consider.
You’ll have more hurdles to jump over when you buy a house in a non-arm’s length transaction, in addition to the regular requirements you have to fulfill when you take out a mortgage. For example, a mortgage lender may require the seller to verify that they are not delinquent on the existing mortgage.
You may be required to put down a specific down payment amount, depending on your lender or loan type. For example, in order to be approved for a non-arm’s length transaction with an FHA loan, your down payment must be equal to at least 15% of the purchase price. There are a few exceptions to this rule that allow your down payment to be 3.5%. They are as follows:
- You’re purchasing the primary residence of a relative, fiance or domestic partner.
- You’re the employee of a builder purchasing one of the builder’s new homes to be your primary residence.
- You’re purchasing a property from a landlord or a family member that you’ve rented for the last 6 months prior to the purchase agreement.
Although this covers FHA loans, other loans may have restrictions. For more information, speak with a Home Loan Expert.
You Could Face A Tax Event
If you’re buying a house from a family member who wants to give you a break through what’s called a gift of equity, more taxes may be involved. Under current Internal Revenue Service laws, an individual can give an equity gift of $15,000 each year or $30,000 for a married couple. After that, it becomes taxable income for the seller. If you buy the house on the cheap and sell it within a few years, you could also be on the hook for capital gains taxes as a buyer. Check with an accountant or tax preparer to find out what your potential tax liability may be.
It Could Cause Family Strife
Not every transaction will alter family dynamics, but some will. Buying a home can be an emotional process, and this can be compounded by transacting with a friend or family member. You should be careful when buying a house from a family member if you think the relationship could be in jeopardy or if other family members might have strong feelings. It’s good to be aware that emotions can run high and to treat the home purchase as a business transaction.
It’s Not Over Until It’s Over
Family members may want to help each other out, but good intentions can sometimes be just that. If there’s a shift in the seller’s financial situation, they could be forced to raise the price, or have to try to get more competitive offers instead of selling the house to you.
Cheaper Closing Costs
One perk of buying a house from a family member means that closing costs will likely be lower. You also won’t need a real estate agent, which can save as much as 6% in commission. There also might be less need for an inspection of the home if you trust the family member you’re purchasing from. There’s also flexibility in the closing date – instead of trying to get two strangers coordinated, it may be easier for both parties to schedule closing and moving dates.
Get approved to buy a home.
And see how much down payment assistance you may need.
What Is A Gift Of Equity?
A gift of equity refers to when your friend or family member sells you the property at a price below the current market value. Typically, this occurs when the sales price is lower than the actual market price of the home and the difference becomes a gift of equity. Many lenders allow the gift to count as a down payment on the home. A gift of equity has several requirements:
- The seller must have an appraisal completed on the home.
- The appraised value must be noted on specific paperwork, which will also list the price the home is selling for.
- Gift equity paperwork must be completed. Among other things, it must state that the gift doesn’t have to be paid back.
- A settlement letter must note the gift during closing.
Buying A House From A Family Member: How It Works
Here are the steps you need to complete if you’re buying a home from a family member.
Get preapproved for a mortgage. During the preapproval process, your lender will verify your credit score, debt-to-income ratio (DTI), income and assets and the down payment you plan to make. You’ll receive a preapproval letter that will tell you how much they’re willing to lend you.
Determine The Purchase Price
To do this, determine the fair market value so your family member can price your home accurately. If there’s a gift involved, determine if your family member is giving you equity, paying closing costs or giving a cash gift. There may be tax implications for all for both the buyer and seller. Check with a tax professional for more information.
Real estate agents have tools at their disposal to determine how a home should be priced. They pore over a comparative market analysis, or comps, to gauge what homes are selling for in the neighborhood and come up with estimates based on those.
When you go into it alone, it’s up to you to figure it out. You can consider hiring an appraiser to complete a full home appraisal to determine the house's fair market value. This can be difficult if the property is located in a rural area or is unique in some way.
Draw Up A Purchase Agreement
The purchase agreement – also called the sales contract – should lay out all aspects of the transaction, including the price and any contingencies – like the home inspection, financing or appraisal contract opt-outs. With this contract in hand, you can contact your lender and officially apply for your mortgage. Be aware that your mortgage may not be approved if your family member isn’t current on their mortgage, so you should confirm that as well before proceeding.
Complete A Title Search
Even if you trust your relative, it’s a good idea to hire a title company to protect you from any liens or to search for anyone else who may have a claim to the title of the home. Your lender will require a title insurance policy for its benefit, and you should consider purchasing one for your own benefit as well.
Consult An Attorney
Buying a house seems straightforward. Especially if you’re buying from a family member, it’s not. Remember: A home is likely the single biggest investment you’ll make, and you’ll want to make sure you get it right. An experienced real estate attorney can help you with contracts and make sure you don’t make any costly mistakes.
Continue Through Underwriting
During preapproval, your lender focuses on your creditworthiness. Once you’ve selected a property to buy, the focus shifts to the value of the home and whether it will cover the lender’s costs should you default on the mortgage. It’s during this stage that your relationship with the seller and the terms of the transaction are closely scrutinized to make sure there is no fraud or undue influence in the deal.
During this time, it’s important not to engage in any activities that could impact your credit utilization ratio. Do not open new credit card accounts or make large purchases on your current credit cards. Even though you’ve been preapproved, lenders will run a last-minute credit check to make sure nothing has changed since the preapproval process.
Close On Your Home
At closing, the title will be transferred and you’ll be given the keys to your new home. But closing doesn’t mean it’s over; if the IRS chooses to, it can take a hard look at any non-arm’s length transaction at any time to make sure it was conducted correctly and that there was no improper motive behind the sale.
Explore your mortgage options.
Apply online for expert recommendations and to see what you can get approved for.
The Bottom Line: Be Prepared For Greater Scrutiny If You Engage In Non-Arm’s Length Transactions
Keeping it all in the family can be a great way to purchase a home. After all, you’re buying a home that may already have sentimental value and you won’t have to fend off competitive bids or pay a real estate agent a commission. Go into the transaction with your eyes wide open.
Learn more about what parents should consider before helping their children with a home purchase. If you’re looking for financing, you can apply online or give us a call at (866) 420-4278.
Viewing 1 - 3 of 3
What Is The Real Estate Gift Tax And How Can I Avoid It?
Mortgage Basics - 5-minute read
Jamie Johnson - May 16, 2023
Real estate gift tax applies any time an individual transfers property to someone without receiving full market value in return. Learn how you can avoid it.
Capital Gains Tax On Real Estate And Home Sales
Home Buying - 7-minute read
Victoria Araj - July 05, 2023
Are you required to pay the capital gains tax on your real estate property? Review our guide to learn what the capital gains tax is, when to pay it and more.