Buying a home can be a tricky, expensive and stressful process. In some situations, you may consider buying a home from a family member or friend. After all, you’d likely get a lower price, go through a quicker process and potentially even have access to owner financing, and wouldn’t it be much easier to deal with someone you already have a great relationship with? You wouldn’t even need a real estate agent!
Whoa. Slow down there.
Buying a home from someone you know might be a great idea, but there are a number of things you need to know before you can sign on the dotted line. Before you’re ready to move into your new home, let’s go through the basics to help you prepare.
What Is an Arm’s Length Transaction?
Real estate transactions can be broken down into two broad categories: arm’s length transactions and non-arm’s-length transactions. An arm’s length transaction is a transaction between two parties who don’t have a relationship with one another – whether that’s a family tie, a business connection, etc. Each party is confidently able to act in their own self-interest. For example, when you buy a house from a stranger, it’s considered an arm’s length transaction.
What Is a Non-Arm’s-Length Transaction?
A non-arm’s-length transaction is a deal with someone you have a relationship with, whether that’s professional or personal. This can include family members, friends, business partners, etc. This type of relationship between buyers and sellers is known as an identity of interest.
When a relationship like this exists, there is a greater chance that one party could manipulate the other party in some way, or both parties could work together to try to cheat the fair market price of the home. This is an example of mortgage fraud.
Example of a Shady Non-Arm’s-Length Transaction
Let’s say that Mary wants to buy a house, and her uncle Sam says he’ll sell his house to her for $200,000. In reality, though, the house is only worth $150,000. Sam – who knows that Mary trusts him – is trying to use his relationship with his niece to inflate the price of the house and get more money. This behavior can be considered mortgage fraud.
Luckily for Mary, there are entire teams within mortgage companies and governmental organizations whose job it is to sift through these types of transactions looking for shady situations. One way they do this is by requiring an arm’s-length principle of transfer pricing. What is that? We’re glad you asked.
What Is an Arm’s-Length Principle of Transfer Pricing?
The arm’s-length principle of transfer pricing requires that the amount charged for a house is the same for transactions between strangers as it is for transactions between those with personal ties. This protects one or more parties from being manipulated by an inflated market value.
Are Non-Arm’s-Length Transactions Illegal?
Non-arm’s-length transactions are legal, but because of their potential for fraudulent situations, they are treated with a higher scrutiny than an arm’s-length transaction. There are more government and individual lender guidelines to follow when trying to get a mortgage for a home. There are a few things lenders want to guard against in family deals, and some of them are for your own benefit.
Because the water can be so easily muddied with family or friend transactions, lenders want to ensure both the buyer and seller are acting in their own self-interest (not under any duress), are agreeing on a price that is close to the market value and aren’t engaging in mortgage fraud, including misrepresentation, straw buyers, inflated prices, etc.
In a short sale, for example, an arm’s length affidavit must be signed to protect against a family member buying the home but allowing the original owner to stay in the home for a greatly reduced mortgage cost.
Should You Buy a House from Family or Friends?
There are a lot of potential benefits to buying a home from a friend or relative, but mixing home sales and family can be a sticky business. Here are a few other things to consider before purchasing a house from family or friends.
With a non-arm’s-length transaction, you’re going to risk running into more obstacles with getting a loan because of all the added restrictions, and you may be subject to extra taxes because the IRS will be watching closely to make sure a fair market value – and interest amount – is paid for the home. If you buy the home at a cheaper price and then sell it within a few years, you may be subject to capital gains taxes as well.
In some situations, other family members or friends who aren’t directly involved with the transaction can become jealous of the situation (for example, if you buy a house that’s been in the family for generations). While this doesn’t have a direct impact on the transaction, it can cause some kinks in your relationships. So be prepared and aware of the overall perception when purchasing a home from a family member or friend.
Shift in Financial Situation
The next potential pitfall is a sudden shift in the seller’s financial situation, which could move them to ask you for more money on the purchase, especially if they provided the loan for you instead of a mortgage lender. While you likely have a group of well-meaning people in your life, money is something that can make many people turn mean fast.
These can be some touchy subjects, but if you’re buying a home, you have to know everything about it, whether you know and trust the seller or not. Use this checklist before moving forward with the purchase:
- Make sure the family member is current with their mortgage payments, because it could impact your mortgage approval if they’re not.
- Work with a title company to protect yourself from any other liens that might be on the property. Many title companies have for sale by owner (FSBO) teams that can help you a lot when you’re not using a real estate agent.
- Get legal advice. This isn’t because you don’t trust your friend or relative, but because you aren’t well-versed in the legal aspects of purchasing a home. An attorney can help you with all the paperwork and make sure you don’t inadvertently commit mortgage fraud.
Buying a home from a friend or relative can seem like a great way to simplify moving into a new home – and it can be. But it’s important to understand how the process works and the potential risks involved. Our Home Loan Experts are ready to help you through the home buying process. If you have questions or comments about any of this, let us know in the comments!
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Source: Home Loans