Arm's Length Transactions in Relation to Commercial Real Estate
In an arm’s length transaction, the buyer of a product does not have a preexisting familial or business relationship with the seller. For instance, if an investor were to sell their sibling an apartment building, the transaction would not be arm’s length, while if they sold a stranger the building, it would be an arm’s length transaction. This has important consequences when it comes to buying and selling commercial real estate. In part, this is due to the fact that lenders may be wary of working with borrowers who are purchasing a commercial property from a relative or business partner. Non-arm's length transactions can also have significant tax implications.
Arm's Length Transactions and HUD Multifamily Loans
The FHA has strict rules when it comes to transactions that are not arm’s length, or, as they would say, so-called “identity of interest” transactions. Borrowers must generally disclose any preexisting relationships they have with any other parties in a transaction, including lenders, sellers (for purchase transactions), and other service providers, such as renovation contractors (for loans involving property rehabilitation). In some situations, an identity of interest between certain parties is forbidden and can prevent a loan application from being approved.
For instance, HUD forbids borrowers applying for their 232 loan program to have an identity of interest with lenders. In other cases, such as the HUD Section 8 Moderate Rehabilitation Loan Program, borrowers must fill out a specific document detailing the exact identity of interest. HUD will generally review these transactions more carefully to ensure that all contracts are reasonable, costs are not excessive, and that a borrower is not simply “paying themselves” with the proceeds from their loan. For example, if the borrower owns a stake in a roofing company, and is using the company to replace the roof of their HUD-financed property, this would not likely be acceptable to HUD.
Arm's Length Transactions in Regard to Short Sales
In regards to commercial real estate short sales, potential buyers with an identity of interest with the seller are typically prohibited from purchasing the property. In fact, most lenders require each party involved in the deal to sign an “Affidavit of Arm's Length Transaction,” affirming that they have no preexisting business or familial relationship. Specifically, lenders fear that a buyer could intentionally underbid on the property in order to sell it back to their relative or business associate. In many cases, short sale lenders do not permit commercial real estate brokers to list properties if they have an identity of interest with the owner. They are also not typically permitted from attempting to sell a property they personally own as a short sale.
Ethical Issues in Non-Arm's Length Transactions
In addition to a borrower “paying themselves” with renovation loan proceeds, or having a family member buy a property during a short sale, other ethical issues can arise from non-arm’s length transactions, specifically, issues between supervisors and employees. For instance, an employee of a company could be threatened with termination or otherwise coerced into purchasing a piece of real estate for (or from) their employer. This is yet another reason why many lenders tend to dislike deals in which the borrower and another party have an identity of interest.
The Tax Implications of Non-Arm's Length Transactions
In many cases, a non-arm’s length transaction will involve one party purchasing a property from another party, sometimes at a significant discount. However, they will still generally need to pay property taxes on the full market value of the property. This is essential to understand if you are considering buying commercial real estate at a discount from a relative or business partner. In addition, attempting to engage in a 1031 exchange with a related party is often more trouble than it’s worth, as the IRS has instituted additional rules involving related-party transactions in order to reduce the potential for tax avoidance.