real estate

How do I properly buy at non-arm's length?

Steve McLindenDear Real Estate Adviser,
I want to purchase a house from my brother-in-law. Am I required to file a non-arm's-length transaction claim of some sort? What happens if I don't?
-- Sonya N.

Dear Sonya,
You're asking, I believe, what your obligation is to the lender and to the government in disclosing your role in a friendly home sale, which doesn't have that typical "arm's length" distance between buyer (you in this case) and seller (your brother-in-law).

While there's actually not a so-called non-arm's-length transaction form to file, there is an Identity of Interest Certification form you may need to fill out if you're getting your mortgage through the Federal Housing Administration, or FHA. The Internal Revenue Service is also interested in non-arm's-length transaction disclosure for different reasons, as we'll discuss later.

Because most conventional mortgage-lending programs still require nearly perfect credit scores to get the best mortgage rates these days, the FHA has had to step in to fill the breech, which means you'll have to play by its rules if you go that way. One of the lines to fill out on the FHA Identity of Interest form reads: "My relationship with the seller is _______." Underneath that, there's another line explaining that it's a federal crime to make false statements concerning the above facts. So it's best to fess up to the non-arm's-length status of your purchase and not fudge any facts. And by the way, lenders and taxing authorities are looking especially close at Identity of Interest issues in short sales these days because so many family members have bought "underwater" houses to lease back to struggling occupants.

Despite the all-in-the-family disclosure, you should still be able to get FHA-insured financing, but only with a maximum loan-to-value ratio of 85 percent. In other words, your down payment would have to cover the remaining 15 percent, which would be $30,000 for a $200,000 home, for example. However, there are some exceptions that might qualify you for maximum financing, such as if you've been renting the home you're purchasing for at least six months predating the sales contract.

Arm's-length restrictions also apply to people buying homes from people who have direct business relationships with them. There are some exceptions here as well, such as when a company transfers a worker to another city, then buys that worker's home to re-sell to another employee.

Now for the tax implications: If your brother-in-law is cutting you a brother-in-law deal and selling at a significant discount, he should be aware of IRS rules on arm's-length transactions and gift giving. A single person can give an annual equity gift of $13,000, and a married couple can gift $26,000 without additional tax liability unless a lifetime gift-giving limit threshold of $5 million has been reached, which is relatively rare except in high-income brackets.

That doesn't mean he can't sell what the market bears. Given the housing-price corrections of the past five years, it's not a stretch in most cases to sell a home for 35 percent less than what it was valued for in 2008. But regardless, he should be careful how he structures the sale, even if he is feeling mighty generous in his pricing. An independent appraisal on the home would give both of you an up-to-date valuation and fair-market value that should help stand up to IRS scrutiny. Also realize that once you buy the home, your local property-tax assessor will calculate your taxes based on what your place is worth, not what you paid for it.

All told, it's best not to straight-arm authorities when it comes to non-arm's-length transactions. Good luck on the deal!

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