Differences in Foreclosure, Short Sale, and REO Distressed Home Sales

A distressed home with boarded up windows being sold as a bank owned REO property.

Benjamin Lowy / Getty Images

Foreclosures, short sales, and REOs remind us of, "Lions and tigers and bears, oh, my!" There are similarities. Lions and tigers and bears are fierce animals, but different from each other. Foreclosures, short sales, and real-estate-owned (REO) properties are all distressed sales but different from each other as well. However, without specialized knowledge about how to handle the purchase of one of these distressed properties you could find yourself in dangerous territory.

For example, while many short sales are foreclosures, not all foreclosures are short sales. Also, not every short sale is in foreclosure. To further complicate matters, REOs are not short sales either, but some intended short sales can end up as an REO. Some of the differences in the three come from where the home is in the process of being sold and who is doing the selling.

Foreclosure Property

A foreclosure property is a home that the owner has received a notice of being in default—behind on their payments. If the situation continues the lender will file the foreclosure with the public records authority of the city or county.

Foreclosure means the owner has stopped making mortgage payments and the lender has given notice that unless the payments are brought up to date, it will sell the property to the highest bidder. Lenders can foreclose for other reasons, but the most common reason lenders file a notice of default is when a borrower is at least two payments in arrears. If the homeowner does not bring the loan current, the lender will take the property away from the owner.

Next, after a certain period has passed, the lender will try to auction the property at a public sale. However, not all homes that fall into foreclosure go to public sale. Owners have the right to make up back payments up to a point, the timing of which varies from jurisdiction to jurisdiction.

Real estate investors and homebuyers see profit in buying foreclosures because they can often buy the property for the amount owed, picking up the home owner's equity for free.

Effects of California Law

States have varying laws governing foreclosures and some follow California law. To completely understand your rights as a foreclosure buyer, contact a local real estate lawyer. However, realize that for a long time in California, a real estate agent could not represent a foreclosure investor if all of the following four statements were true:

  • The home qualifies as the seller's personal residence.
  • The property is a single-family home or two to four units.
  • A Notice of Default has been filed in the public records against the property.
  • The investor buyer will not occupy the property.

However, if any of those four statements were false, an agent in California would be allowed to represent buyers, especially if the buyer was going to occupy the home. To represent an investor, CA law requires that a real estate agent post a bond. No such bond is available in the state of California. Therefore, as a pre-foreclosure investor in California, many buyers were forced to act on their own.

A California court ruled in 2007 that the bond requirement was unenforceable. Realize, as an investor, you are required to comply with the Home Equity Sales Act. Among other requirements, sellers who are in foreclosure have the right to rescind (cancel) a transaction within five days. Investors must give the seller notice of that right, including a copy of the form that will let sellers cancel.

Failure to comply with the Home Equity Sales Act carries severe penalties, including a provision that gives the seller the right to cancel the sale up to two years after the sale and closing to the investor and get the property back. As an investor, before you decide to buy a home in foreclosure by making up the back payments to the lender, giving the seller a few dollars and recording a deed, call a real estate lawyer.

Short Sales

A short sale occurs when the sale price is less than the outstanding mortgage on the property. Short sales often happen when homeowners are in financial trouble, but not necessarily in default on their loan yet.

A lender must agree to accept less than the amount that is owed on the property under a short sale. Unlike a foreclosure, investors typically buy the home for even less because investors are not paying off the existing loan nor making up the back payments. Investors are striking a deal with the existing lender to take less than what the lender has coming to avoid dealing with a foreclosure.

It is a myth that lenders are not going to make a deal with an investor unless the seller has fallen behind on the seller's obligation to make timely mortgage payments. Sellers don't need to be in default for a short sale to occur. For a buyer who wants to occupy the home, buying a short sale makes financial sense.

Owned by the Lender

Buying an REO is similar to buying a short sale except the property is already owned by the lender. Bank-owned properties are called REOs, which stands for Real Estate Owned by the lender.

Banks end up owning the property when nobody at the public auction bids enough to cover the amount owed against the property. REO homes are often considered the best way to buy a distressed property because the seller is already out of the picture. It's just the investor, the investor's agent, the bank and the bank's agent who are negotiating the transaction. Some REOs can be purchased directly from the lender. For more information, seek the advice of a real estate lawyer.

The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.

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The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. California Fourth District Court of Appeal, Fourth District. "Schweitzer v. Westminster Investment Inc."

  2. California Civil Code. "Chapter 2.5. Home Equity Sales Contracts (1695-1695.17)."

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