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.
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. Buying a house from a parent or someone else close to you is what’s known as a non-arm's length transaction and can come with some important information to be aware of.
A non-arm’s length transaction is when the buyer and seller have a personal relationship. A sale between friends, family or co-workers is considered to be a non-arm’s length transaction. With a non-arm’s length home sale, self-interest may not be the motivation – like a parent selling 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 a Federal Housing Administration (FHA) loan, a non-arm’s length transaction is known as “identity of interest.”
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.
Non-arm’s length transactions aren’t illegal. However, they face more scrutiny than arm’s length transactions because there could be a higher chance of fraud when both parties have a relationship.
Markets depend on the competitive 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. That’s why non-arm’s length deals are subject to transfer pricing. This means that the sale price for the home has to be the same as if you were to undergo a deal between strangers.
Lenders offering conventional loans and government-backed mortgage loans may have different guidelines on the types of relationships and transactions that are considered non-arm’s length.
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 led to regulations where lenders must do their due diligence on 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 is when a property is sold for less than the amount owed on the mortgage. An arm’s length affidavit protects a lender against a type of mortgage fraud. Essentially, it prevents situations where borrowers 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.
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.
Buying a house in a non-arm’s length transaction can create additional requirements 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. Another restriction could be that you might be required to put down a specific down payment amount, depending on your lender or loan type.
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:
Although this covers FHA loans, other loans may have restrictions. For more information, speak with a Home Loan Expert.
If you’re buying a house from a family member who wants to give you a gift of equity, more taxes may be involved. Under current Internal Revenue Service laws, an individual can give an equity gift of $18,000 each year or $36,000 for a married couple.
After that, it becomes taxable income for the seller. If you buy the house inexpensively 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.
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. Be careful when buying a house from a family member if it might jeopardize your relationship or if other family members might have strong feelings. It’s good to be aware that emotions can run high, so it’s wise to treat the home purchase as a business transaction.
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.
One perk of buying a house from a family member is 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. It can also make your closing date more flexible. Instead of trying to get two strangers coordinated, it may be easier for both parties to schedule closing and moving dates.
A gift of equity refers to when your friend or family member sells you the property at a price below 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:
Here are the steps you need to complete if you’re buying a home from a family member.
Get started with the approval process for a mortgage here. During this 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.
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 both the buyer and seller. Check with a tax professional for more information.
Real estate agents have tools to determine how a home should be priced. They review comparative market analysis, or comps, to gauge what homes are selling for in the neighborhood. From there, they come up with an estimate.
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.
The purchase agreement – also called the sales contract – should lay out all aspects of the transaction. This should include 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. This is also a good time to verify that your family member is current on their mortgage payments since lenders could reject your application if they aren’t.
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.
A home is likely the biggest investment you make in your life, and you 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. Buying from a family member or friend might lend an added sense of security. However, it can also make the transaction more complicated.
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 if you default on the mortgage. During this stage, your relationship with the seller and the terms of the transaction are closely scrutinized to make sure there is no fraud or undue influence.
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.
At closing, the title will be transferred and you’ll be given the keys to your new home. Closing a non-arm's length transaction doesn’t always mean you’re at the end of the process. It’s good to be aware that if the IRS chooses to, it can take a hard look at any non-arm’s length transaction at any time.
This is so they can make sure it was conducted correctly and that there was no improper motive behind the sale. Having a tax professional or real estate attorney who specializes in these types of transactions on board can help ensure that if the IRS looks at your transaction, everything is handled properly.
Keeping it all in the family can be a great way to purchase a home. After all, you’re buying a home that may have sentimental value. You won’t have to fend off competitive bids or pay a real estate agent a commission. That said, non-arm’s length transactions can cause complications. So, make sure you go into the transaction with your eyes open. Ready to buy a home? If you’re looking for financing, you can get started on a mortgage application or give us a call at (866) 420-4278.
Kevin Graham is a Senior Blog Writer for Rocket Companies. He specializes in economics, mortgage qualification and personal finance topics. As someone with cerebral palsy spastic quadriplegia that requires the use of a wheelchair, he also takes on articles around modifying your home for physical challenges and smart home tech. Kevin has a BA in Journalism from Oakland University. Prior to joining Rocket Mortgage he freelanced for various newspapers in the Metro Detroit area.