The short version
- In the finance world, arm’s length refers to a fair, open market transaction where the buyer/seller has no prior relationship — or their relationship has no impact on the outcome of the sale.
- Non-arm’s length transactions, such as selling a car to a friend at half-price, aren’t inherently illegal. But since they’re so often used to hide fraud, they tend to attract more scrutiny from lenders, regulators, and other stakeholders.
- Investors in the real estate and crypto/NFTs spaces will want to understand the difference, as spotting a non-arm’s length transaction may one day help them avoid fraud, scams, or a letter from the IRS.
What is an arm’s length transaction?
In simple terms, an arm’s length transaction is one in which the buyer(s) and the seller(s) conduct a fair trade on the open market with no collusion, pressure, or prior relationship influencing the outcome of the sale.
Some examples of arm’s length transactions include:
- Selling a car to a friend for Kelley Blue Book value
- Selling an NFT to an anonymous high bidder on OpenSea
- Buying a home through your respective real estate agents without meeting the owners
- Purchasing shares of (VOO) via TD Ameritrade from an anonymous seller
In contrast, buying/selling any of the above assets to 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-in-arm transaction.
Of course, there’s nothing inherently illegal about (most) arm-in-arm transactions. Your car is your property, and nothing stops you from selling it to whomever you want for $1. Similarly, there’s nothing wrong with inheriting 100 shares of Microsoft.
But trouble arises when one or both parties abuse the privacy of a non-arm's length transaction to avoid taxes, paperwork, or the law itself.
It happens all the time, which is why there’s generally more scrutiny of non-arm’s length transactions. The IRS, mortgage 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 put $2,000 on the Bill of Sale so they can save on taxes. What may seem like a small favor that doesn’t impact your bottom line could have you facing legal consequences later (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 straddle 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 detail.
Why arm’s length matters
If you ask the IRS, they’ll say an agreement passes the arm’s length test — or what they call the Arm’s Length Standard — if one of the following conditions are met:
- Two uncontrolled parties made 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 matters because, historically speaking, regulatory bodies, mortgage lenders, and stakeholders scrutinize non-arm’s length transactions more carefully.
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’ll tell you that keeping things at arm’s length is a big honkin’ deal in the real estate world. The more the buyer and seller know about each other, the more it creates opportunities for fraud, steering, bias, and manipulation:
- If a predatory investor learns that the seller is older and not of sound mind, he may take advantage of the situation.
- If a seller learns of a buyer’s race, religion, vocation, gender identity etc., they may treat their offer more or less favorably.
- When a real estate agent “steers” a buyer to specific neighborhoods based on the above factors, this could also be a non-arm’s length since the agent influences a transaction in which they receive a commission.
That’s also why some real estate agents may refuse to send your buyer’s “love letter” to a seller; it instantly converts the transaction from arm’s length to arm-in-arm. This could unintentionally hurt the buyer, but moreover, it 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 kind is a breeding ground for fraud. For example, most lenders will make you sign an Arm’s Length Affidavit before approving a short sale. This keeps you from just selling the property to a friend to erase your mortgage. And even if you sell a house 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’re related to the buyer/seller, speak to your CPA, be 100% transparent with your lender. And prepare yourself for a lot of extra paperwork.
And even if you score a family discount as the buyer, you’ll still have to pay taxes, insurance, and more based on the full market value.
Arm’s length transactions in the stock market
Arm’s length vs. non-arm’s length comes up less often in the stock world. Most shares are traded over 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 extra paperwork) if your gift amount exceeds the Gift Tax limit of $16,000 in 2022 or $17,000 in 2023.
Funny enough, insider trading might not be considered arm-in-arm since there’s no transaction of stocks taking place between the two parties — just an exchange of information.
But here’s where arm’s length vs. non-arm’s length may still be relevant for stock market investors: if you see signs of arm-in-arm activity at the highest levels of a company (nepotism, collusion, antitrust violations, etc.), it could be a sign that litigation is coming.
Arm’s length transactions in the crypto/NFT space
As mentioned throughout this piece, regulatory bodies are incredibly wary of non-arm’s length transactions. Why? Because they’re so often used to hide fraud.
Nowhere is this more apparent than in the still-largely-unregulated digital asset space. A 2018 study 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 arm-in-arm transactions, obfuscating Bitcoin’s fair market value — and arguably — planting the seeds of the 2022 crypto crash.
Meanwhile, “wash trading” continues to plague the NFT space, causing confusion and sapping investor confidence. For the uninitiated, wash trading is when someone buys and sells an asset repeatedly to create the illusion of greater 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 wash traded their 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 by CryptoSlam found that 95% of trades on the popular NFT platform LooksRare could be attributed to wash trading.
The takeaway for crypto and NFT investors? Impending regulations may not be such a bad thing. As the SEC or whoever begins shining a light on illicit non-arm’s length transactions, it could bring safety, stability, and new investors to the market.
More: Biden's crypto executive order: What's in it?
The bottom line: Arm yourself with information
Arm’s length transactions put the “open” in open market, providing transparency, fluidity, and a fair chance to more investors.
That’s not to say arm-in-arm transactions are inherently bad — just that they understandably invite more scrutiny. And if you’re involved in one, you should apply that extra scrutiny yourself.