The U.S. Treasury will soon finalize a plan to expand its incentives for mortgage companies to include short sales as a way to stem a rising tide of foreclosures, according to a Treasury spokeswoman.

Short sales, or sales of homes for less than the balance on existing mortgages, are seen as a key way to supplement other efforts such as loan modifications to steady housing. Unlike most modifications, short sales eliminate the problem of negative equity that has become a big reason for defaults as home prices have plunged.

The incentives, first announced in May, would expand the government's Home Affordable Modification Program that has seen limited success in lowering payments for hundreds of thousands of homeowners deemed eligible. Just 12 percent of homeowners eligible have had their loans reworked, leaving millions more foreclosures to come, the Treasury said on September 9.

More short sales may alleviate fears that a raft of shadow supply, or foreclosures in the pipeline, will flood the market and deal a blow to the nascent rebound in housing seen over the U.S. summer months, analysts said. The overhang of supply is currently about 7 million units, or 135 percent of a year's of existing home sales, according to Amherst Securities Group.

What they are trying to do is move some of these foreclosures in the pipeline, and bring them to a resolution before (foreclosure) happens, said Lisa Marquis Jackson, a vice president at Irvine, California-based John Burns Real Estate Consulting. 12 percent of these being modified isn't enough to clean these up.

Realtors express frustrations with banks when trying to negotiate a short sale, which can take four to five months to complete, according to John Burns consultants. Buyers often walk away from sales because banks are slow to respond, or balk at the offer.

The Treasury will use up to $10 billion from a previously announced $50 billion pool of mortgage modification funds for payments to address lender concerns that home prices will continue falling in high-cost areas.

Incentives will be calculated on recent declines of local home prices and average home prices in these markets, the Treasury said in May. They would add to other incentives that servicers can receive for reducing loan payments.

In May, the Treasury proposed lenders would receive a $1,000 payment for allowing the owner to sell the house for less than the amount owed on the mortgage, and accepting the proceeds as full repayment. They can also receive $1,000 for accepting a similar deed-in-lieu transaction, in which the deed is simply transferred to the lender instead of going through a costly foreclosure.

Borrowers who agree to short sales or deed-in-lieu deals can received up to $1,500 in closing costs. Treasury also said it will pay second lien holders up to $1,000 to relinquish their claims in such transactions.

Presumably, the Treasury is trying to help facilitate a transaction that will result in less loss to the lender than in the case of a foreclosure, John Burns consultants said in a research note dated Oct 1 alerting clients of an impending Treasury announcement.

(Additional reporting by Emily Kaiser and David Lawder in Washington; Editing by Diane Craft)