With the declining number of REO foreclosures on the market right now, many investors and wholesalers are having success acquiring properties through short sales. However, dealing with REO foreclosures and short sales can be two very different animals. While buying and selling an REO is typically straight forward, the laws surrounding the reselling of a short sale are quite different.
For those new to real estate: a short sale is a real estate transaction in which the seller has received approval from their lender to sell the property “short” of the actual loan balance (i.e. for less than what is owed on the mortgage). For example, you may owe $100,000 on your mortgage, but values in the area have fallen and the house is worth less than this. Rather than getting foreclosed by your lender, you sell the property for $70,000 and the lender agrees to accept $70,000 as payoff of your mortgage.
Many investors gravitate towards short sales because there is often an opportunity to buy and sell the property for a profit (similar to a foreclosure). Sometimes this involves buying a property in need of repair, renovating it and selling it for a profit. Sometimes this may simply involve negotiating a good deal with the bank and finding a buyer who is willing to pay more. Interestingly, this second scenario is typically illegal and can land an investor in serious trouble.
Most investors will read this and think to themselves , “Why would it be illegal for me to negotiate a good deal on a short sale and simply mark it up to another buyer?” Believe it or not, Freddie Mac considers this “short payoff fraud”. They define short payoff fraud as; “Any misrepresentation or deliberate omission of fact that would induce the lender, investor or insurer to agree to the terms of a short payoff that it would not approve had all facts been known.” In most cases, the fraud occurs because the investor does not disclose to the lender the fact that there is another buyer involved in the transaction.
In the example above, suppose the property is sold to the investor for $70,000, but the investor has an offer from another buyer for $80,000. The investor plans on reselling the property immediately after closing for a quick $10,000 profit. If the investor discloses to all parties that his/her intention is to sell the property for $80,000 and everybody agrees to this arrangement, then there is no problem. However, this is typically not how the scenario plays out. Most investors don’t even realize they are committing fraud, but by not disclosing the transaction whereby the investor sells the property to another buyer for $80,000, the investor commits fraud (by omission) and can get in serious trouble.
I realize most investors will argue that a good negotiator should have the ability to earn a quick buck for getting a good deal on a property. I’m a staunch capitalist and tend to think this way as well. However, when it comes to getting into legal trouble, I’d rather understand how the courts interpret “fraud” and do my best to stay as far away as possible. This is one of those topics where being an educated investor isn’t just about being profitable, it’s about staying out of trouble!