Short Sale Fraud: Three Scams to Avoid

Short sale buyers and sellers need to watch out for these common fraud scenarios.

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If you are one of the many homeowners having difficulty paying your mortgage, you may be considering a short sale of your home. A short sale is a sale of a property where the proceeds of the sale are less than the balance owed on the mortgage covering the property. As the number of homeowners and buyers considering short sales increase, so does the number of incidents of short sale fraud. Short sale fraud schemes come in different guises, but a few are more common than others. Short sale buyers and sellers should be on the lookout for the three scams discussed in-depth here. (For a broader look at short sales, read Nolo's article Short Sale of Your Home: Is It Right For You?)

Short Sale Scam #1: Undisclosed Payments

Victims: Sellers, buyers, lenders.

Perpetrators: Sellers, junior lien holders, real estate agents, short sale negotiators.

Red Flags: Payments made "outside of escrow" or "off the settlement statement."

How It Works: Lenders approve short sales to avoid foreclosure and minimize their losses. Before giving their approval, lenders often do one or more of the following:

  • Reduce commissions to real estate agents.
  • Require that sellers receive no financial benefit from the sale.
  • Reduce or even disapprove payments to other parties involved in the short sale (e.g., short sale negotiators, attorneys, etc.).

Primary lenders will also cap payments to junior lenders. If there is more than one loan on the property, the short sale will not go through without the release of the junior liens. In order to get this release, the primary lender will allow some payment to the junior lenders but will set a cap on these payments.

As you can imagine, those receiving reduced or capped payments are often unhappy with this situation. Taking advantage of highly motivated buyers or sellers, they request payments "outside of escrow" or "off the settlement statement." As a buyer or seller involved in a short sale, you may be tempted to make an undisclosed payment just to get the deal done. By doing so, however, you would most likely be a party to loan fraud.

All payments made as part of a short sale transaction should be disclosed to the lenders and other parties approving the short sale. According to Freddie Mac, short sale fraud occurs when someone deliberately misrepresents a fact or omits a fact in order to induce a lender, investor, or insurer to agree to a short sale that it would not have approved if it had known the truth. How do you know whether a certain payment would have affected a lender's decision to approve a short sale? You don't. To be safe, disclose.

Short Sale Scam #2: "Flopping"

Victims: Sellers, lenders.

Perpetrators: Real estate agents, buyers.

Red Flags: Double escrows; buyer is an LLC or a fictitious entity or purchasing under a power of attorney; purchase agreement gives buyer the option to resell property.

How It Works: "Flopping" occurs when a short sale is approved based on a misrepresentation of the value of the property. In a typical flopping fraud, the fraudster is the buyer purchasing the property from the short sale seller. In some cases of flopping, the seller's real estate agent is the buyer. The fraudster presents a low offer to purchase the property to the lender along with an artificially low valuation of the property, in order to convince the lender that the property is worth less than it really is. Meanwhile, any higher offers from bona fide buyers are withheld from the lender, since the lender would most likely reject the low offer if it knew that higher offers were on the table. Once the lender approves the short sale at the artificially low price, the fraudster contacts the bona fide buyer or markets the property at its true market value. Without the short sale lender's knowledge, a second escrow between the fraudster (as the seller) and a bona fide buyer is then opened to close simultaneously with the first purchase, or soon afterward. The perpetrator of the fraud buys low, sells high, and keeps the difference between the two sale prices.

Sellers can also be hurt by flopping, because lenders may hold sellers responsible for the deficiency, or the amount of the difference between what the seller owed and the sale price. If a lender forgives a seller for the deficiency, the seller may owe taxes on the amount of debt that is forgiven. (To learn more about income tax liability in short sales, see Nolo's article Short Sales and Deeds in Lieu of Foreclosure.)

Short Sale Scam #3: Predatory Short Sale Negotiators

Victims: Sellers, buyers.

Perpetrators: Short sale negotiators, real estate agents.

Red Flags: Upfront fees; fees required to be paid outside of escrow; negotiator is not licensed.

How It Works: Sellers considering short sales are particularly vulnerable to con artists hoping to take advantage of their stressful situations. These con artists, calling themselves short sale negotiators (or short sale processors, short sale coordinators, short sale expeditors, debt negotiators, debt resolution experts, loss mitigation practitioners, or foreclosure rescue negotiators) guarantee results for a flat fee or a percentage of the sale price. Oftentimes, the short sale negotiator takes the fee and does nothing or little in return.

Some states -- including California, Washington, and Oregon -- require short sale negotiators to be licensed by the appropriate state agency (most likely the agency responsible for licensing and regulating real estate agents). If you are considering hiring a short sale negotiator, you should contact your state's agency to find out whether short sale negotiators need to be licensed and, if so, whether the short sale negotiator you are planning on hiring is indeed licensed. In California, it is illegal for short sale negotiators to collect fees in advance of providing services, unless certain stringent requirements are met. You should also check if this is the case in your own state.

Before hiring a short sale negotiator, do your due diligence. Read documents carefully before signing. Ask questions. Ask for and contact references. Seek the advice of an attorney or other neutral third party. (To find an attorney in your area, visit Nolo's trusted Lawyer Directory.) Remember, if it sounds too good to be true, it probably is.

Additional Information

For more information about foreclosure rescue scams, get the Foreclosure Survival Guide by attorney Stephen Elias (Nolo), now also available from Nolo online at no charge. If you are a victim of a short sale fraud scheme or other foreclosure rescue scam, contact your state attorney general's office (find your state's attorney general on Nolo's State Resource pages), the U.S. Department of Housing and Urban Development (www.hud.gov), or the Federal Bureau of Investigation (www.fbi.gov).

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