This article/post contains references to products or services of one or more of our advertisers or partners. We may receive compensation when you click on links to those products or services.
“Let’s keep things at a distance.”
It may sound like a pretty conversational thing to do, but if someone is telling you this in the context of a big purchase or investment, they’re probably not playing a game.
This is because, in the world of money, conducting a transaction at arm’s length versus non-arm’s length has serious tax, legal, and security implications. Therefore, it is essential that all investors know the difference.
So what is an arm’s length transaction? What is a non-arm’s length transaction? What is the difference and why is it important in the context of real estate, stocks, and crypto/NFTs? Keep reading.
the short version
- In the world of finance, a level playing field refers to a fair and open market transaction in which the buyer/seller has no prior relationship, or their relationship has no impact on the outcome of the sale.
- Transactions that are not at arm’s length, such as selling a car to a friend for half price, are not inherently illegal. But because they’re so often used to hide fraud, they tend to attract more scrutiny from lenders, regulators, and other interested parties.
- Investors in the real estate and cryptocurrency/NFT spaces will want to understand the difference, as spotting a non-arm’s length transaction may one day help them avoid fraud, scams, or an IRS letter.
What is an arm’s length transaction?
In simple terms, an arm’s length transaction is one in which the the buyer(s) and the seller(s) conduct a fair trade on the open market without collusion, pressure or previous relationship that influences the result of the sale.
Some examples of arm’s length transactions include:
- Sell a car to a friend for Kelley’s Blue Book worth
- Selling an NFT to an anonymous high bidder on OpenSea
- Buy a home through their respective real estate agents without knowing the owners
- Purchase of shares of (FLIGHT) through TD Ameritrade from an anonymous seller
Conversely, buying/selling any of the above assets from someone you know for a discount, or without listing the asset on the open market, would likely constitute a non-arm’s length transaction, also known as an arm-to-arm transaction.
Of course, there is nothing inherently illegal about (most) hand-to-hand transactions. Your car is your property, and nothing prevents you from selling it to whoever you want for $1. Similarly, there is nothing wrong with inheriting 100 shares of Microsoft.
But problems arise when one or both parties abuse the privacy of a transaction without arm’s length conditions to avoid taxes, paperwork, or the law itself.
It happens all the time, which is why there is usually more scrutiny of non-arm’s length transactions. He IRSMortgage lenders and anyone involved in the sale will want to know what happened “behind the veil.”
For example, if you sell your car for $10,000, the buyer might ask you to add $2,000 to the bill of sale in order to save on taxes. What may seem like a small favor that doesn’t affect your bottom line could see you face legal consequences down the road (specifically, for fraud).
That’s why investors in all sectors need to understand the difference between arm’s length and non-arm’s length. At some point, you may cross the line, or someone will ask you to, and knowing the difference can save you from a bad deal, a scam, or a rather nasty letter from the IRS.
So let’s dive into more details.
Why arm’s length matters
If you ask the IRS, they will tell you that an agreement passes the arm’s length test, or what they call the Arm length standard — if one of the following conditions is met:
- Two non-controlled parties entered into the agreement freely and independently of each other, or;
- The results were the same as if the two parties had operated freely and independently of each other.
This definition is important because, historically speaking, non-arm’s length transactions are more carefully scrutinized by regulators, mortgage lenders, and interested parties.
Here are some examples of where the line is in each sector and why it matters:
?️ Arm’s length transactions in real estate
Ask any real estate agent and they will tell you that keeping things at arm’s length is a big deal in the world of real estate. The more the buyer and seller know each other, the more opportunities are created for fraud, misdirection, bias, and manipulation:
- if a predatory investor finds out that the seller is older and not in his right mindYou can take advantage of the situation.
- if a seller learn from a race, religion, vocation, gender identity, etc. of the buyer., they may treat your offer more or less favorably.
- When a the real estate agent “directs” a buyer to specific neighborhoods based on the above factors, this could also be a non-compete distance as the agent influences a transaction in which he receives a commission.
That is also the reason why some real estate agents may refusing to send your buyer’s “love letter” to a seller; instantly converts the transaction from arm to arm. This could inadvertently harm the buyer, but also, subjectively violates the standards of a 100% free and open market.
Lenders also tend to have strong preferences for arm’s length sales, since the other type is a breeding ground for fraud. For example, most lenders will have you sign an arm’s length affidavit before approving a short sale. This prevents you from selling the property to a friend to clear your mortgage. And even if you sell a home for $1, the buyer will still have to pay taxes on the fair market value.
The bottom line for real estate investors is this: Everyone treats non-arm’s length transactions with more scrutiny. If you are related to the buyer/seller, talk to your CPA, be 100% transparent with your lender. And be prepared for a lot of additional paperwork.
And even if you get a family discount as a buyer, you’ll still have to pay taxes, insurance, and more based on full market value.
? Arm’s length transactions in the stock market
Arm’s length versus non-arm’s length distance appears less frequently in the world of stocks. Most shares are traded on an open market where buyers and sellers remain anonymous.
If you gift shares of a stock to someone, you may have a small tax liability (or at least additional paperwork) if your gift amount exceeds the gift tax limit of $16,000 in 2022 or $17,000 in 2023.
Interestingly, insider trading might not be considered heads-up, as there are no stock transactions between the two parties, just an exchange of information.
But this is where arm’s length versus non-arm’s length conditions may still be relevant to stock market investors: If you see signs of joint activity at the highest levels of a company (nepotism, collusion, antitrust violations, etc.), it could be a sign that litigation is looming.
₿ Arm’s length transactions in the crypto/NFT space
As mentioned throughout this article, regulators are incredibly wary of non-arm’s length transactions. Why? Because they are often used to hide fraud.
Nowhere is this more apparent than in the digital asset space that is still largely unregulated. A study 2018 found evidence that up to 50% of Bitcoin’s epic 2017 rally could be attributed to a handful of covert players manipulating the market through joint transactions, obfuscating Bitcoin’s fair market value and possibly planting the seeds of collapse. cryptographic of 2022.
Meanwhile, “wash trading” continues to plague the NFT space, causing confusion and undermining investor confidence. To the uninitiated, wash trading is when someone repeatedly buys and sells an asset to create the illusion of increased demand and artificially inflate prices. It’s illegal in traditional financial markets, but in the crypto/NFT space, all someone needs to do is create multiple wallets.
As a result, some NFT holders laundered their traded assets up to a “market value” of $1 billion. And while that number was clearly too high to fool anyone, other numbers haven’t been. One study found that 10% of buyer-seller pairs accounted for more trading activity than the other 90%. An analysis from CryptoSlam found that 95% of operations on the popular NFT platform LooksRare could be attributed to wash trading.
The takeaway for cryptocurrency and NFT investors? The impending regulations may not be so bad. As the SEC or whoever begins to shed light on illicit, non-arm’s length transactions, it could bring safety, stability, and new investors to the market.
Curious why logs are good for crypto? >>> Biden’s Crypto Executive Order: What’s in it?
The bottom line: Arm yourself with information
Arm’s length transactions put the “open” on the open market, providing transparency, fluidity, and a fair opportunity for more investors.
That’s not to say that head-to-head transactions are inherently bad, just that they understandably invite more scrutiny. And if you’re involved in one, you need to apply that extra scrutiny yourself.
Other reading:
