A Primer on “Arm’s Length Transactions”
The purpose of this article is to explain “arm’s length transactions” in real estate in California. This concept is important because this type of transaction or sale for property may affect the deed or contract surrounding the transaction. It also affects property taxes and the value of a property at the time of sale.
What does an “arm’s length transaction” mean?
An arm’s length transaction means a transaction between two parties conducted as if the parties are strangers regardless of how closely related or affiliated, they might be. (Black’s Law Dictionary (10th ed 2014)). This is indicates the absence of a conflict of interest. (In re Rexford Properties, LLC (2016) 557 B.R. 788, 797.)
In an arm’s length transaction, the duties owed between the parties is limited the duty An example of this is between a borrower and a lender in a loan transaction. A financial institution (the lender) does not owe a duty of care to a person (the borrower) when it is just lending them money. (Rufini v. CitiMortgage, Inc. (2014) 227 Cal.App.4th 299, 311–312.) In this type of arm’s length transaction, the lender does not have a special duty, like a fiduciary duty, owed to the borrower.
Arm’s length transactions also create special rules for contracts and agreements. In an arm’s length transaction where the terms of an agreement can be modified or rejected, strict rules apply. In this type of transaction, parties are bound by the terms of the contract even if they do not read it. Someone accidentally or purposefully failing to read a contract may assume associated loss. (Markborough California, Inc. v. Superior Court (1991) 227 Cal.App.3d 705, 716–717.) For example, a party may include a clause in a contract to limit their liability in doing construction on a property. In this type of arm’s length transaction, that clause would be enforced whether or not the party signing onto it read the contract.
How does it affect the value of a property?
Arm’s length transactions for the sale of property can affect its appraised value. An appraisal allows for the full cash value or fair market value of property to be determined by an assessor before the property is actually bought. (California Minerals, L.P. v. County of Kern (2007) 152 Cal. App. 4th 1016, 1023.) This full cash or market value is the purchase price paid in the sale unless it can be proved that the property would not have been sold for that price in an open market transaction. (Id.) If the sale was negotiated and completed at arm’s length, the purchase price is presumed to be the full cash or market value. (Id.) An arm’s length sale may affect property value for the purposes of property tax. The assessed value of an arm’s length sale will determine the fair market value of the property for tax purposes. (Id.)
Separately, if a sale was an open market arm’s length transaction that establishes an “actual market” for that specific property. This allows the assessor to be bound by that sale price in determining the value of the property. (Guild Wineries & Distilleries v. County of Fresno (1975) 51 Cal.App.3d 182, 185–186.) However, while an open market arm’s length sale of a property may be an important factor in determining its value, it is not the only factor in appraising the property. It can be an unreliable indicator for the assessor, so market value is generally established by looking at numerous sales of the same or comparable property. (Dennis v. County of Santa Clara (1989) 215 Cal. App. 3d 1019, 1027-1028.) Looking at the market value in sales like this is meant to ensure fairness and transparency as to how the specific type of property is bought and sold. (Western States Petroleum Assn. v. Board of Equalization (2013) 57 Cal. 4th 401, 422.)
The arm’s length sale rules also apply to the price of rentals resulting from a lease. In an arm’s length transaction, rental properties must be leased for the same amount demanded by someone privately leasing for profit if a government is doing the leasing. (Treasury Regulations § 20.2032A-4.) This also applies to leases between family members. Because the sale is meant to be at “an arm’s length” and eliminate conflicts of interest, one party cannot give another party a “friends and family” discount or other form of preferential pricing.
How does it affect partition actions?
A sale at an arm’s length must be negotiated like it is between sellers and a stranger. Even if sellers and plaintiffs were known to each other and had done business previously it is presumed they negotiated the sale like strangers. Specifically, it is assumed that the current leases on the property would have the same impact as on sellers and any buyer. And would not change if the parties knew each other. (Dennis v. County of Santa Clara (1989) 215 Cal.App.3d 1019, 1027.)
The use of an arm’s length transaction can help clarify ownership and transfers of property. Because it is meant to prevent conflicts of interest, an arm’s length sale can show a clear intent on the part of the seller to pass the property and associated rights and interests to the buyer. (Bill Signs Trucking, LLC v. Signs Family Limited Partnership (2007) 157 Cal.App.4th 1515, 1528.) In partition disputes where arguments over ownership frequently arise between parties who are related or know each other, an arm’s length sale can prevent future disputes. An arm’s length sale can help show an intent to transfer property and prevent the sale from seeming biased.
What is an example?
For example, “Julie” wants to pass her home onto her son “Shawn.” However, Shawn is not her only son. Her other son Peter is estranged and no longer speaks to her. Julie knows if she passes the home onto Shawn, Peter will try to dispute the sale or transfer. Julie is concerned Peter will try to contest Shawn getting the house in pointing to comments she made in passing a few years prior about passing her property onto her kids. Julie wants to ensure the sale is as easy as possible to make sure Shawn keeps the house and that Peter contesting ownership does not create a larger familial dispute. Julie can transfer the property by an arm’s length open market sale. Having the property appraised and the sale conducted at an arm’s length strengthens the appearance of objectivity. The appraisal ensures Julie is not selling the property to Shawn at a discounted price and is instead selling it at the market price she would get for it if she sold it to a stranger. Shawn will pay that price and the property taxes based on that price. This sale allows for a clear transfer of property rights from Julie to Shawn and will make it more difficult for Peter to contest.
Conclusion
An arm’s length sale or transaction occurs between two parties acting as strangers even if they know each other to make the sale fair and objective. In an arm’s length sale, terms of a contract or negotiation are binding. For a property, its sale price must reflect that of the market value so as to not give any preference to the buyer. This also applies if rental properties are being leased through an arm’s length.
The Underwood Law Firm has a team of experienced lawyers who can help resolve your color of title issues as they relate to partition and help you pursue solutions to ensure clarity of title. We are here to help.