Many clients asks me this very important question and truthfully my answer has always been the same. Short sale is a bad idea but it has good ramification. It can prolong your foreclosure process while you can legally stay free in your home and not obligated (at least legally) to pay your mortgage payments. There are some potential problems with short sales.
First, a Chapter 7 discharges the underlying mortgage debt, as well your personal obligation for your second mortgages, HELOCs, equity lines, etc.) A liquidation bankruptcy would discharge all of your debts including the principal balance as well as HELOC.
Second, if you’re in bankruptcy, you can’t do a short sale without Court approval. This often means that you have to pay your lawyer more money to do something that has no financial benefit for you. Again, a short sale may be rejected by the bankruptcy as a collusive transaction.
Finally, even though you’re in bankruptcy, the lender may still issue a 1099-C. This means that you will need to file a Form 982 to avoid having to pay income taxes on the forgiven debt.
It is a good idea to negotiate that the lender would not come after you and file a deficiency judgement.