In California, if the loan on the home is a purchase money loan, which is the one used to purchase the home, and not refinanced, then in a foreclosure situation, the banks are not in a position to pursue you for a personal deficiency. In other words, they cannot sue you for the loss on the home. We had our lawyers check this out and it's due to laws dating back to the Depression era.
At the time that a house is sold, there are three parties agreeing to the price: the buyer, the appraiser, and the mortgage lender. So if a home goes down in value, all parties share the risk. It's no different than a VC investing in a small business. If the business fails, the VC cannot sue the managers of the business to get their money back. The same holds true with foreclosures in California. In the depression, this same situation happened, property values fell, people lost their jobs and were sued by the banks to pay them back. Bad stuff.
We are both pursuing short sales of our homes, but are perfectly OK with a foreclosure. In both situations, our credit ratings will take a huge hit, but they recover in 7 years for a foreclosure, and in 2 years if it's a short sale. So we asked ourselves, is our credit score worth 300K? And with some simple financial modeling, we figured that it was about 10 years for the property values to break even. And the trade off was simple.
The short sale does turn into cancelled debt, though, and the IRS will get a 1099-C. Cancelled debt counts as income, which makes it taxable. Except the US govt passed the 2007 mortgage debt relief act, which makes cancelled debt from a mortgage tied to your primary residence an exception. You do not have to pay income tax on it. This is valid through the 2012 calendar year.
At the state tax level, if the home has cancelled debt, it's still seen as a loss sales against the orginal value of the home. And losses are not taxable.
So this is a great situation financially - no liability to the mortgage company, no federal or state tax. Really bad credit for a couple years :(. But as a question of opportunity cost, this seemed to make the most sense.
In order to pursue this, both of us had to stop making all payments on the mortgages. We both got harrassing debt collection calls for awhile, but once you get into the foreclosure process, they eventually die down. We each will get 6-12 months of living in our homes for free, so in some ways that is a loss recovery.
Hope this helps some of you...