How it works
You list the house with an agent, find a buyer, and send the lender a hardship letter, financial documents and the offer. The lender decides whether to approve the price. Nothing closes without that written approval.
A short sale can take months, and the foreclosure clock does not automatically stop while the lender reviews it. Ask the servicer in writing whether the sale date will be postponed.
Get the shortfall waived in writing
The difference between what the house sells for and what you owe is called the deficiency. Some approval letters waive it and some do not. Before closing, make sure the approval letter says the lender accepts the sale as payment in full and waives any deficiency. If there is a second mortgage or home equity line, you need a release from that lender too.
The tax question
Debt a lender forgives can count as taxable income, and the lender may send you a Form 1099-C. There have been federal exclusions for forgiven debt on a main home, and there is a separate exclusion if you were insolvent when the debt was forgiven, claimed on IRS Form 982. Whether an exclusion applies depends on the year and your situation, so talk to a tax preparer before you file.
Short sale or foreclosure?
Both damage your credit. A short sale usually lets you qualify for a new conventional mortgage sooner. Fannie Mae generally requires a four year wait after a short sale and seven years after a foreclosure. FHA borrowers can ask about the FHA Pre-Foreclosure Sale option.