diff --git a/workspaces/arborist/lib/arborist/build-ideal-tree.js b/workspaces/arborist/lib/arborist/build-ideal-tree.js
index 1edd0b643b60d..7d22c2f19ff0b 100644
--- a/workspaces/arborist/lib/arborist/build-ideal-tree.js
+++ b/workspaces/arborist/lib/arborist/build-ideal-tree.js
@@ -1238,15 +1238,19 @@ This is a one-time fix-up, please be patient...
       // Check if the target is within the project root
       isProjectInternalFileSpec = targetPath.startsWith(resolvedProjectRoot + sep) || targetPath === resolvedProjectRoot
     }
+
+    // When using --install-links, we need to handle transitive file dependencies specially
+    // If the parent was installed (not linked) due to --install-links, and this is a file: dep, we should also install it rather than link it
+    const parentWasInstalled = parent && !parent.isLink && parent.resolved?.startsWith('file:')
+    const isTransitiveFileDep = spec.type === 'directory' && parentWasInstalled && installLinks
+
     // Decide whether to link or copy the dependency
-    const shouldLink = isWorkspace || isProjectInternalFileSpec || !installLinks
+    const shouldLink = (isWorkspace || isProjectInternalFileSpec || !installLinks) && !isTransitiveFileDep
     if (spec.type === 'directory' && shouldLink) {
       return this.#linkFromSpec(name, spec, parent, edge)
     }
 
-    // if the spec matches a workspace name, then see if the workspace node will
-    // satisfy the edge. if it does, we return the workspace node to make sure it
-    // takes priority.
+    // if the spec matches a workspace name, then see if the workspace node will satisfy the edge. if it does, we return the workspace node to make sure it takes priority.
     if (isWorkspace) {
       const existingNode = this.idealTree.edgesOut.get(spec.name).to
       if (existingNode && existingNode.isWorkspace && existingNode.satisfies(edge)) {
@@ -1254,6 +1258,15 @@ This is a one-time fix-up, please be patient...
       }
     }
 
+    // For file: dependencies that we're installing (not linking), ensure proper resolution
+    if (isTransitiveFileDep && edge) {
+      // For transitive file deps, resolve relative to the parent's original source location
+      const parentOriginalPath = parent.resolved.slice(5) // Remove 'file:' prefix
+      const relativePath = edge.rawSpec.slice(5) // Remove 'file:' prefix
+      const absolutePath = resolve(parentOriginalPath, relativePath)
+      spec = npa.resolve(name, `file:${absolutePath}`)
+    }
+
     // spec isn't a directory, and either isn't a workspace or the workspace we have
     // doesn't satisfy the edge. try to fetch a manifest and build a node from that.
     return this.#fetchManifest(spec)
diff --git a/workspaces/arborist/test/arborist/build-ideal-tree.js b/workspaces/arborist/test/arborist/build-ideal-tree.js
index 32bc6b25ed39c..aadc09e3bee7d 100644
--- a/workspaces/arborist/test/arborist/build-ideal-tree.js
+++ b/workspaces/arborist/test/arborist/build-ideal-tree.js
@@ -4389,4 +4389,64 @@ t.test('installLinks behavior with project-internal file dependencies', async t
     t.ok(nestedDep, 'nested-dep should be found')
     t.ok(nestedDep.isLink, 'nested-dep should be a link (project-internal)')
   })
+
+  t.test('installLinks=true with transitive external file dependencies', async t => {
+    // mainpkg installs b (external file dep) with --install-links
+    // b depends on a (another external file dep via file:../a)
+    // Both should be installed (not linked) and dependencies should resolve correctly
+    const testRoot = t.testdir({
+      a: {
+        'package.json': JSON.stringify({
+          name: 'a',
+          main: 'index.js',
+        }),
+        'index.js': 'export const A = "A";',
+      },
+      b: {
+        'package.json': JSON.stringify({
+          name: 'b',
+          main: 'index.js',
+          dependencies: {
+            a: 'file:../a',
+          },
+        }),
+        'index.js': 'import {A} from "a";export const fn = () => console.log(A);',
+      },
+      mainpkg: {
+        'package.json': JSON.stringify({}),
+      },
+    })
+
+    const mainpkgPath = join(testRoot, 'mainpkg')
+    const bPath = join(testRoot, 'b')
+    createRegistry(t, false)
+
+    const arb = newArb(mainpkgPath, { installLinks: true })
+
+    // Add the external file dependency using the full path
+    await arb.buildIdealTree({ add: [`file:${bPath}`] })
+
+    const tree = arb.idealTree
+
+    // Both packages should be present in the tree
+    const packageB = tree.children.get('b')
+    const packageA = tree.children.get('a')
+
+    t.ok(packageB, 'package b should be found in tree')
+    t.ok(packageA, 'package a should be found in tree (transitive dependency)')
+
+    // Both should be installed (not linked) due to installLinks=true
+    t.notOk(packageB.isLink, 'package b should not be a link (installLinks=true)')
+    t.notOk(packageA.isLink, 'package a should not be a link (transitive with installLinks=true)')
+
+    // Verify that the resolved paths are correct
+    t.match(packageB.resolved, /file:.*[/\\]b$/, 'package b should have correct resolved path')
+    t.match(packageA.resolved, /file:.*[/\\]a$/, 'package a should have correct resolved path')
+
+    // Verify the dependency relationship
+    const edgeToA = packageB.edgesOut.get('a')
+    t.ok(edgeToA, 'package b should have an edge to a')
+    t.ok(edgeToA.valid, 'the edge from b to a should be valid')
+    t.equal(edgeToA.to, packageA, 'the edge from b should point to package a')
+  })
 })