What an appraiser needs to know about arm's length transactions

Arm's length transactions are not always easy to define.

Arm's length transactions are not always easy to define.

Arm's length transactions seem to have a slightly different meaning depending on who is asked, leaving them somewhat open to interpretation. This can make an appraiser's role a bit more complicated during a home sale process, as he or she is supposed to identify if the sale is "arms length,"  meaning reflecting market value, and not distorted by a relationship between buyers or sellers, and not a distress or forced quick sale.

Michael S. Bolton is a real estate appraiser who is in the habit of calling any agents involved with the process before he begins his appraisal. The point of this communication is to find out if the sale is actually closed, and if it was an arm's length transaction. According to his website, he is one of few appraisers who take the time to make this call, which he found to be surprising.

"Arm's length transactions are not always straightforward."

"Apparently not all appraisers must be doing this, because I get a lot of Realtors telling me that this is first that anyone has asked these questions," Bolton stated on his real estate appraisal blog.

So why the confusion surrounding arm's length transactions? And what is an appraiser's role in such a sale?

Arm's length transactions defined
An arm's length transaction occurs when buyers and sellers act independently in their intentions and have no relationship with each other. The point of such a transaction is to ensure each party is acting in his or her own self interest without any pressure from another party.

Because of this, real estate that is bought and sold in this type of deal tends to go for fair market value, or as close as possible. Essentially, since neither party has any affiliation with the other and both are acting out of self interest, the buyer will want to spend as little as possible, and the seller will intend to make as much as he or she can from the deal. Fair market value is likely the common ground these parties can come to and be satisfied.

This may sound like an obvious type of sale, but there are many instances when this is not the case. For example, if a father is selling property to his son, it is unlikely that fair market value will be reached, as the father will typically be generous in the deal. These are non-arm's length transactions, and they are popular in the real estate industry.

However, the difference between an arm's length transaction and a non-arm's length transaction is not simply as straightforward as that.

Differences in definitions
There are various definitions for what constitutes an arm's length transaction, and while the above description is accurate, there are variations that can make a big difference. For example, as Appraisal Buzz noted in the U.S. Department of Housing and Urban Development's 2015 handbook, the definition of an arm's length transaction specifically states the transaction meets market value. Well, this particular wording has caused some appraisers to ask questions.

Why? Because even in a non-arm's length transaction, market value can be reflected. For example, if a grandmother sells her grandson a piece of property at market value, is it an arm's length transaction? The parties know each other, so some appraisers and real estate professionals would say no because of the relationship between the buyer and seller.

Whether or not an arm's length transaction was how the value was reached dis important to know.Appraisers need to know whether or not a home sale was reached through an arm's length transaction.

However, fair market value was reached, and according to HUD's definition, this is all that's necessary to define an arm's length transaction. On the flip side, a transaction could take place well below or above market value for the sake of time, as either a buyer or seller may be under duress to make the transaction quickly. What if these parties don't know each other, but agree on a price well below or above market value? Is this an arm's length transaction?

While an appraiser will not be deciding what type of transaction took place, it does matter that he or she knew the details prior to an appraisal. There are some loan officers who consider non-arm's length transactions too risky to be involved with, as it makes it so the value of a piece of property isn't as clear as it should be, as noted by Metrobrokers. There can also be various tax consequences placed on non-arm's length transactions, as less money is typically being exchanged.

Communication and research are best
Before appraising a piece of property, an appraiser must be aware of the transaction history. This might sound redundant to some, but with a gray area of confusion regarding arm's length transactions, appraisers should ask questions of agents and loan officers involved in the buying and selling process.

Since an appraiser's duty is to establish value, whether for tax purposes or for a sale, determining the property's history is necessary. Even when various definitions tend to have muffled or conflicting lines, appraisers need to be aware and able to navigate the process. Only by affiliating him or herself data on with arm's length transactions and analyzing them in detail can an appraiser complete this task accurately.