In real estate, a short sale is when a bank or mortgage lender agrees to discount a loan balance due to an economic hardship on the part of the mortgagor. The home owner/debtor sells the mortgaged property for less than the outstanding balance of the loan, and turns over the proceeds of the sale to the lender in full satisfaction of the debt. In such instances, the lender would have the right to approve or disapprove of a proposed sale.

Extenuating circumstances influence whether or not banks will discount a loan balance. These circumstances are usually related to the current real estate market climate and the individual borrower's financial situation.

A short sale typically is executed to prevent a home foreclosure. Often a bank will choose to allow a short sale if they believe that it will result in a smaller financial loss than foreclosing.

In short; A short sale is nothing more than negotiating with lien holders a payoff for less than what they are owed, or rather a sale of a debt, generally on a piece of real estate, short of the full debt amount.

Lenders have a department (typically called a loss mitigation department) which processes potential short sale transactions.

In the United States the number of short sales being accepted by lenders rapidly grew during 2007 and is expected to reach record levels in 2008.

Update Feb. 4, 2008 - The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief.

This provision applies to debt forgiven in 2007, 2008 or 2009. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion doesn’t apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

The amount excluded reduces the taxpayer’s cost basis in the home. More information on claiming this exclusion will be available soon.

Source irs.gov