Pulling equity from your primary res or from any other source for that matter, and using the proceeds to pay off worthless bad-risk debt is nothing but throwing good $$$ after bad. Same thing with credit cards. In this particular instance, you're just making the banks richer and you poorer. You're giving them the upper hand. In this market, values are past the point of NO RETURN.
Now, pulling out the equity and putting the money into a asset or investment exempt from creditors (such as your lender), however, is the smartest hedge in light of yours and many others' similar scenarios. You always protect against the worst of odds. If you have zero equity, you're in a much better position to re-negotiate loan terms in your favor. It's doubtful a lender will look at your loan re-negotiation with equity in your house. They will you to sell the house and pay them off which only an idiot would do! You are a sitting duck for the vultures!
Thus, if you are judgement-proff, and the deal turns to crap (the lender stonewalls you), pull the plug on them! Credit and borrowing for investors is meaningless now and it will take at least 2-5 years before lending returns to normalcy anyway.
Furthermore, I wouldn't count on values for rental properties coming back anytime within the next 5-10 years.
So, again, I would first judgement-proof myself, then, if you have to default in order to get the lender to consider you, do that. At least you're protected against the worst-case scenarios.
I would first try for a loan mod to salvage what you worked hard for, even pitch the lender on reducing principle in exchange for getting some of the appreciation when prices rebound. Try anything before throwing in the towel and short selling or worse, foreclosing.
Regarding the 1099-C, as long as you didn't pull a second or HELOC on the property you're short selling, the loss you incurred from the cost basis less the selling price
wipes out the forgiveness gain that must be reported from the 1099-C (assuming the difference of your loss exceeds the amount of the gain). It's simple math and a good accountant can take care of that. I don't know why everyone is so concerned with the 1099-C issue. Again, as long as the loan being short sold was a purchase money loan (not a refi), the loss cancels the gain which results in zero tax liability.
Another method to avoid the debt forgiveness gain is to show insolvency to the IRS at the time the property was sold short. Now, how many borrowers aren't in some kind of hardship if they have to short sell??? I don't know any.
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