It has been a little while since we have seen a default market, and if you are new to the industry, the idea of a default market may be foreign to you. With the federal foreclosure moratorium set to expire on July 31, 2021, our industry should be prepared to handle the types of transactions that result from mortgage defaults. These transactions include foreclosures, deeds in lieu of foreclosure and short sales. So, let’s look at short sales.
A short sale is the conveyance of real property where the purchase price is less than the total amount of loans and other obligations encumbering the property. In order for a title insurer to be willing to insure, all parties holding liens and encumbrances against the property must agree to release or terminate their respective interests upon completion of the short sale.
A lender will often agree to a short sale because it results in a larger recovery for the lender, since there are lower costs and expenses incurred as opposed to those which accompany the foreclosure process. For example, let’s consider a borrower in default on a mortgage with a principal balance due in the amount of $420,000. The lender might be willing to take a short sale payoff of $390,000. Why? Even though the payoff is $30,000 less than the total outstanding balance owed, the lender would likely suffer less of a loss than if they proceeded through a lengthy foreclosure. Even if the foreclosure purchase price was $390,000, the lender may only recover $365,000 after deducting advertising costs, attorneys’ fees, court costs, holding costs, taxes, maintenance fees, etc.
Short sales tend to be cyclical based on the economy. While other circumstances may lead to a short sale (for instance, the value of a particular property declining due to damage from a fire, hurricane, tornado, etc. or a large employer in a certain area ceasing operations, leading to declining property values), they are more common in recessive markets when real estate prices are generally declining. Because of this, we need to be aware of the red flags present in these types of markets.
We need to be aware of opportunistic investors collaborating with property owners to make a quick profit. In these situations, a seller may be working with an investor purchaser who assists the seller in obtaining an appraisal that supports a short sale. The investor then quickly “flips” the property at a higher price. Insuring “flip” transactions is risky in general, even where there is no short sale involved, so it is imperative that agents submit these transactions to their underwriting counsel for review. The agent should also reach out for underwriting review if the property has been transferred within the prior 12 months and any of the following three conditions are present:
Agents should also be mindful of lenders protecting themselves. Often the debt forgiven as part of the short sale is reported to the IRS as income to the seller. The lender may require the seller to execute a new, unsecured promissory note in the amount of the debt forgiveness. If this is the case, the commitment for the transaction should contain a requirement for the new promissory note.
The components of short sale transactions – the Lender’s Affidavit, the Closing Instructions, the Short Sale Approval, the Settlement Statement and the Title Update – should all be carefully analyzed. You will need to review each of these thoroughly and comply with the terms. Here is a brief look at each of these components.
The settlement agent will likely be asked by the lender to join in an affidavit with the buyer and seller regarding the nature of the transaction. It is the best practice for the settlement agent to ensure that all representations are accurate and correct. The settlement agent should only sign the affidavit after it is executed by the buyer and seller. The Lender’s Affidavit may include the following:
The Closing Instructions will contain short sale specific provisions to which the agent should pay close attention. You should look for an acknowledgment that the settlement agent is in receipt of a Short Sale Approval. It will also contain an agreement to execute the short sale and an obligation of the settlement agent to disclose to the lender any information that contradicts the information in the Lender’s Affidavit. You will also see acknowledgments that the short sale may have tax consequences to the seller, that the settlement agent did not provide any legal advice regarding the effect of the transaction documents, and that seller and buyer had the right to consult with an attorney of their choosing.
The Agent should be intimately familiar with the terms and conditions of the Short Sale Approval. One specific condition is that the lender may reject the short payoff and refuse to release their lien if any of the proceeds paid to the seller (or any other party to the transaction) exceed the amounts allowed in the Short Sale Approval. Most often, the seller is not allowed to receive ANY proceeds from the sale, and an appraisal will be required. It is imperative to note that the agent must not attempt to negotiate any of the terms of the Short Sale Approval. The seller and his/her attorney, if any, should be the only parties negotiating the short sale.
The agent must be certain to update the Short Sale Approval just prior to closing. Short Sale Approvals are usually for a fixed amount, with no per diem interest figures; therefore, the lender should be contacted to update the payoff prior to the closing. The lender should be contacted even if the loan is a line of credit that has been frozen. In addition to confirming that the numbers have not changed, the settlement agent must verify that there has been no foreclosure since many lenders will manage separate tracks for the foreclosure and the short sale. Some states have prohibited this by law; however, you should still verify that the property has not been foreclosed.
The Short Sale Approval may contain language prohibiting the buyer from reselling or “flipping” the property. The approval may also prohibit a change in the buyer which may prevent the buyer from selling. Lenders are taking this seriously as some lenders have created a task force to follow up on short sales to see if there were changes to the parties to the transaction or if the property was resold soon after the closing. If any of these terms are included in the Short Sale Approval, the issuing policy must contain an exception for the prohibition on transfer.
The agent should take special care with the accuracy of the Preliminary and Final Settlement Statements. The Preliminary Statement will assist the lender in determining whether the short sale transaction will be approved, and the figures and amounts in the Final Settlement Statement must exactly match the Short Sale Approval. Before closing, the lender must approve the Final Settlement Statement. It is important to note that most Short Sale Approvals do not permit any payments to the seller or any junior lienholders.
Updating the title prior to recording is crucial. The agent must confirm that no new documents have been recorded since the date of the title commitment, as the recording of any intervening matters may void the Short Sale Approval. Additionally, if the title search or title update reveals a Notice of Default or other indication that the foreclosure process has commenced, the agent should contact the foreclosure attorney and/or trustee to ensure the agent has all the attorneys’ fees on the Settlement Statement. Please note that these fees may increase on a per diem basis, and the agent should keep close contact with the foreclosure attorney to keep each other informed of the progress of both the short sale transaction and the foreclosure.
Insuring short sale transactions is more complex and involved than many other title transactions. It is important that the agent read and re-read the terms of the Short Sale Approval and accompanying transaction documents. As always, NATIC agents can rely on NATIC underwriting counsel to assist you.
As a general rule, property of the estate may not be conveyed or encumbered without an order from the bankruptcy court.
Justin Tanner is Vice President, Southeast Regional Underwriting Counsel at NATIC/Doma.
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