Example

The owner of a house with a current market value of $200,000 is 90 days late on their mortgage payment. The bank is on the verge of foreclosing on the property, which in a down market is the last thing they want to do. If it gets to the point of foreclosure, the bank risks either a) not selling the property at all or b) selling it for considerably less than the appraised value of the property.

A prospective buyer comes along and quickly learns that the seller owes $200K property, so that is the best price he can get. However, the buyer then decides to contact the bank directly and make them an offer. The Buyer's intent is to get the bank to agree to a short sale. He makes them an offer of $150K they counter with $170K and voila, they strike a deal.

If you ever wondered how people were making money by posting signs looking for distressed buyers - with phrases like "NO EQUITY, NO PROBLEM" the short sale is how.

Bankapedia's Take

While a short sale seems to be a positive alternative to foreclosure, it certainly has its pitfalls. One is that the short seller typically will not divulge the potential tax implications. The difference between the mortgage balance and the short sale price is known as "deficiency" and can be treated as taxable income. The only way to avoid this is to prove financial hardship, which many sellers simply cannot do. Many times, the seller may have money in a SEP or 401K and simply does not want to part with it, and uses the short sale as a means of starting fresh.

If your payment has become too much of a burden, try and talk to your lender first and see if you can renegotiate the terms of your mortgage. In a down market lenders become far more willing to work things out, as their alternatives are a foreclosure or short sale.