(from the March-April 2007 edition of Coldwell Banker Residential Brokerage SPIRIT newsletter)

A short sale occurs when a seller with financial problems and no equity sells a home for less than the amount of the existing loan balance.  The lender agrees to forgive debt, absorb the loss, and pay commissions and closing costs.  The seller gets nothing, the lender gets a partial payoff, and the real estate agent earns a commission.

Why would a lender agree to this?

A lender with a troubled borrower wants to minimize its costs.  A lender would consider a short sale if the projected costs would be less than those of the alternative:  foreclosure, possible repairs, marketing, commissions and closing costs. 

Lenders, like banks and mortgage companies, are in the business of lending money, not owning real estate.  A foreclosed home is a black mark on their financial statements, and the costs of owning real estate divert funds from additional mortgage lending and other banking operations. 

Note--  if you are a seller considering this option:

Please be sure to discuss the tax implications of a short sale with a professional tax advisor.  The forgiveness of debt may be a taxable event.  A short sale will also have an impact on your credit rating.