You recieved some good advice below. Certainly when you get in the IRS and Law, you need to consult a professional. I've know and seen a lot of situations that grew into bigtime trouble. The early in the process you determine your direction the better.
Best of luck!
I'm an attorney (licensed in MD/DC) and real estate broker (licensed in MD/VA/DC); please feel free to call me to discuss further.
You should check with an attorney regarding the suit.
The IRS reporting of the 1099 (their loss = your gain) is totally unrelated to their attempt to recover the loss in court, and the filing has more to do with their debt write-off than your liability, which may be waived under recent rules.
You should work through the first trust holder to try to satisfy the second. They may have more to gain by working out a (partial) payment to the second trust holder. This would allow the short sale to proceed and avoid a costly foreclosure process in which the second could lose everything anyway. Usually an offer of a "small" payment will satisfy them against a total loss.
You should talk to your agent or short sale negotiator about all this...or call me if you don't have one.
You can also see the Long & Foster affiliate website for short sales in the web reference below.
Second mortgages are more and more going after people for debts if they did not sign a release that does not allow them to persue the deficency.
Talk to a tax perfessional and credit expert or attorney to address the issues.
Wish you luck
First Weber Group
Certified Distressed Property Expert