Editor’s note: This is Part 1 of a two-part series.

Working with distressed real estate listings is not for the faint of heart. Navigating through the minefield of a short sale or foreclosure takes skill and awareness to avoid having your deal blow up — or even worse, your business.

RealtyTrac recently reported that approximately 25 percent of all transactions in the third quarter of 2010 involved a distressed property. Bank-owned (REO) and short-sale transactions will continue to be a major part of the real estate landscape in 2011. To avoid being blindsided when working with distressed properties, here are some important pitfalls to avoid.

1. Are you adequately trained to handle this business?
Many agents try to be all things to all clients. When it comes to distressed properties, this is a dangerous strategy.

If you lack experience dealing with short sales or REOs, then it’s smart to refer the business to another agent and take a referral fee. Failure to do so may jeopardize your business.

It can also be construed as a violation of Article 11 of the Realtors Code of Ethics: "Realtors shall not undertake to provide specialized services concerning a type of property or service that is outside their field of competence unless they engage the assistance of one who is competent on such types of property or service, or are fully disclosed to the client."

In other words, if you are not adequately trained in selling REOs or handling short sales or foreclosures, you need to fully disclose that fact to your clients. Alternatively, you must seek the assistance of your manager or someone else who has the experience to navigate through the process.

2. Lack of awareness about the financial ramifications
Suppose a past client is being transferred to another city and contacts you about listing his home. When he sees the comparable sales, he realizes that he is completely upside down in the property.

The question is: What do you do next? Do you list the property and hope that you will be able to do a short sale? Do you advise your client to walk away? Do you suggest a deed-in-lieu of foreclosure and possibly getting a reimbursement from a "Cash for Keys" program?

Most agents will make some sort of recommendation. However, that would be a huge mistake because the agent can’t possibly know the seller’s exact financial situation or the tax consequences of the seller’s various choices.

3. Recourse or nonrecourse loan?
Whenever you begin working with an owner of a distressed property, you must determine how many loans he or she has on the property and whether those loans are recourse or nonrecourse loans.

With a recourse loan, if the lender forecloses or grants a short sale, the lender can still seek a deficiency judgment after the sale. In other words, the lender may seize other assets belonging to the defaulting homeowner to cover the lender’s loss.

With a nonrecourse loan, the lender’s only option is to foreclose on the property. The lender may not seek a deficiency judgment.

The challenge you face in terms of advising a client to go through with a short sale or doing a deed-in-lieu of foreclosure is that the owner may have both recourse and nonrecourse loans on the same property, which means one or more loans may be subject to deficiency judgments while other loans on the property are not.

Even if this is not the case, it’s still critical that your clients are fully informed about the tax ramifications of their choice prior to committing to any type of transaction. Insist that they see their tax professional to determine their exact tax consequences before they make any final decisions.

4. Have an attorney review all lender listing agreements
Many lenders have incorporated language in both their listings and sales contracts that calls for a "blanket indemnification of the lender."

In other words, if there is a lawsuit, not only do you have to defend yourself, you also have to defend the lender as well. Because of this, it is critical that an attorney review all lender listing agreements in order to remove any blanket indemnification language.

5. Unknowingly engaging in property management is especially dangerous
Many agents unwittingly engage in property management. For example, if the agent turns on the utilities at an REO in his or her name or provides other types of services that are considered to be property management, the agent may lack errors and omissions insurance for these activities.

The reason is that in most agent and brokerage "errors and omissions" policies, property management activities are specifically excluded. If you are sued and your errors and omissions insurance policy does not cover property management activities, you and your brokerage could be found responsible for paying for your respective defenses as well as the lender’s defense from your own pocket.

Protect yourself by reviewing your errors and omissions policy and refrain from engaging in property management if you lack the correct coverage.

These are not the only distressed property pitfalls you may face. See Part 2 of this series to learn more.

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