By now we all know that a short sale is a transaction in which a property is sold for less than the amount owed to the lien holders. In Arizona, the usual course of business is to write a promissory note, which is evidence of the debt (some states still use mortgages, which are different). Then, a Deed of Trust is recorded (the note is sometimes, but not always recorded; there is no recording requirement for any of this) which established rights of the holder of the promissory note to cause a foreclose if the terms of the note are not followed.

When someone does not pay, the holder of the note tells the trustee (the holder of the trust deed) to initiate foreclosure proceedings to get the property back. The first thing the trustee does, in the course of proceeding to foreclosure, is to notify anyone who has an interest in the property. How do they figure this out? They look in the records at the county recorder’s office.

This became of interest to me recently, because a client told me that, while there were two conventional lenders involved with his property (two banks), there was also a 3rd, private party, who had a note naming his home as security. I looked in the records at the county recorder and could find no evidence of this note. Further, my client told me that the 3rd lien holder was surprised to learn that the property was facing foreclosure, as he had not been notified in any official way.

So what happens when either a short sale is completed and closed, or a foreclosure occurs, and there is an outstanding, unrecorded lien? Of course I turned to my fellow blogger and attorney Mr. Widener, who writes:

The validity of a note is not determined by recording. A lien has to be recorded in order to give notice to title searchers. A lien is still valid as between the grantor and its grantee if not recorded, but non-recordation would divest the lienholder of its ability to upset a foreclosure. Non recording of the lien likely makes it possible to estop the lienholder from overturning the short sale, also. A bona fide purchaser at the short sale without notice of the recorded lien and no ACTUAL notice of the lien’s existence takes title free of the lien.

So this is good news… except…

As a Real Estate licensee, now I have reason to know that this 3rd lien exists, and I am bound to disclose this information to a prospective buyer. I suppose if the seller had not told me about it, things would be different, but I must disclose this information to the buyer, and to the title company; Title likely will not insure the transaction without a sign off from the 3rd, and they will go attempt to locate and talk to the lien holder as part of their title search process.

Ultimately the rules are there to protect buyers, and they work reasonably well.