First of all, what is a short sale? It is simply paying the lender less than the amount due on your mortgage loan in exchange for a release of lien against the real estate.
Why would a lender agree to this? Foreclosure is much more time consuming and expensive. The lender owns your property after foreclosure, and is responsible for maintenance, taxes, and most importantly, selling the property. So, accepting a short sale is sort of a "bird in the hand" theory. The lender knows the property is sold, and they know exactly what they are going to receive. With foreclosure, it can take months (even years) before the property is sold, and there is no way to know how much the lender will get when it eventually sells.
Why isn't the the perfect plan to avoid foreclosure? There are some risks involved for the home owner. Most people think that they no longer owe the money because the mortgage has been released. That is not necessarily the case. More often than not, the lender wants all the money to which they are entitled--and who can blame them. This point needs to be negotiated. If the lender actually does forgive the debt, another potential pitfall is the tax liability of the forgiven debt. Since you are given a "gift" of not having to pay back the money, this can be considered income. There are circumstances where you would be responsible for the taxes on this forgiven debt.
How do you do it? There is a great deal to be aware of when you try to do a short sale. Please don't try to do this on your own. Make sure you hire a competent real estate attorney to assist you. Your attorney will probably need your written authorization to contact the lender. Your attorney will prepare a preliminary settlement statement so that the lender can see that the sale price of the home is not sufficient to pay off the loan. Some lenders will require hardship letters. Some will even want appraisals so they can see you aren't selling the property for less than you could.
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.