On the face of it, foreclosures, short sales and REOs look like the same thing: someone can't pay their mortgage and is losing the property to the lender. They are attractive for investors looking to pick up a property for less than market value, and may well represent the next "it" thing in real estate investing.

However, it's not quite as easy as it seems. If you walk into the investor market wanting to "do foreclosures," without understanding the entire process, you could wind up in trouble. For example, while all short sales are foreclosures, not all foreclosures are short sales, and while REOs are not short sales, some short sales can wind up as REOs.

Let's start at the beginning, then, with three basic definitions:

1. What is a Foreclosure?

When a property is in foreclosure, the owner has stopped making payments, and the lender has given the borrower a written Notice of Default that the payments must be brought up to date or the property will be sold off. The notice is a public document (which is why so many websites offer foreclosure lists). It normally takes about two missed payments for a lender to issue a Notice of Default, but not always.

If the owner doesn't respond to the Notice of Default or make the payments needed to reinstate the mortgage, the lender can apply to the courts to take back the title the property so it can then be auctioned off or otherwise disposed of. This doesn't happen right away, though. Each state has a different time period during which the former owners can still rescue the property.

Foreclosure auctions are usually public -- in fact in Reno, NV, foreclosure auctions are still done on the front steps of the Courthouse once a week.

2. What is a Short Sale?

A short sale happens once a home is in foreclosure, but before the property goes to public auction. Short sales are attractive to investors, because lenders often agree to take less than what is owed on the property. The idea here is that you are saving the lender time and money by stopping the legal foreclosure process and taking the property off the lender's hands.

But there are pitfalls to short sales. For example, if multiple mortgages are involved an investor must strike a deal with all lenders. That may leave little, if any, profit margin, depending on how heavily the property is mortgaged. And, even if a lender does agree to an offer up front, they can still change their mind. A real estate agent I spoke with recently told me that in her area, one lender was refusing to close on short sales at the last minute -- wasting time and money for everyone involved.

3. What are REOs (or Real Estate Owned)?

If no-one bids high enough to meet the lender's price at auction, the foreclosure completes and title transfers to the lender. Real Estate Owned means the property is owned by the lender.

Some investors see REO homes as the best way to buy property because there are no emotions involved: it's strictly business between the investor, their agent, the lender, and its agent. And because most lenders aren't landlords (nor do they want to be), investors can often get a very reduced price.

But not always. Sometimes there are hidden fees, like unpaid taxes, penalties, etc., to contend with. Other times lenders aren't willing to negotiate the price down from market, or close to market. This is especially true in areas where home values have fallen further than lenders want to acknowledge.

As with any other kind of investing, education and experience will be crucial. Where foreclosure investing is involved, you may be wise to keep them in that order.

Published: August 15, 2007

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Diane Kennedy, the nation's pre-eminent tax strategist, is owner of Diane Kennedy & Associates, a leading tax strategy and accounting firm and founder of TaxLoopholes. She is the author of The Wall Street Journal and Business Week bestsellers, Loopholes of the Rich and Real Estate Loopholes, and co-author of The Insider's Guide to Real Estate Investing Loopholes, The Insider's Guide to Making Money in Real Estate, and TaxLoopholes for eBay Sellers. Register for free Tax Strategy updates and e-Newsletters delivered via email from TaxLoopholes.com. You will be updated on current tax law changes as well as proactive tax strategies the wealthy use plus news regarding Diane Kennedy.