I've assisted a couple of attorney friends with similar cases in Florida on behalf of the grantor (seller) on a Contract For Deed in which the buyer failed to make the mortgage payments (I provide "forensic" underwriting services to the on behalf of their clients).
A couple of general points to consider from my non-expert experience:
1.) The lender is under no obligation to deal with you since the mortgage contract is between the seller and his/her lender
2.) If you have breached your contract with the seller to make his/her mortgage payments, and if the breach has caused a loss or damages to the seller (such as late mortgage payments being reported on the seller's credit report), the seller may have cause to sue you for the damage of the negative credit reporting in addition to damage resulting from the failure to complete your side of the contract (ie the unpaid balance ofthe $355k purchase price).
3.) The lender won't care about the contract between you and the seller since the lender is not a party to that contract. The lender will pursue the seller for the breach of the mortgage contract between the seller and the lender. Even if the seller is able to pick up those mortgage payments again, damage from the breach of the sales contract still remains.
4.) Any possbility of a short sale will depend on the seller qualifying for a short sale agreement with his/her lender. If a short sale agreement is consumated by the lender and seller, you may still be liable to the seller for the breach of your contract with him/her.
In the Florida cases with which I am familiar, the plaintiffs (sellers) were successful in winning judgments against the buyers for the unpaid balance of the Contracts for Deeds PLUS damages for late mortgage payments made by the buyers on behalf of the sellers.
It depends on how the Contracts for Deeds are written. In both cases, the properties reverted back to the sellers (one buyer had spent more than $80,000 in repairs and improvements) and the judgments allowed the sellers to seize other assets owned by the buyers for partial satisfaction of the judgments.
You are in a very unfortunate circumstance. It is best to not delay in hiring an attorney and try to work out some sort of agreement wth the seller before the seller becomes aware of the breach by receiving a Notice of Default on the mortgage you took over.
The other answer appears to be correct, but I don't believe this is your only problem. I would suggest that you speak to a lawyer. I went to a class this weekend regarding foreclosures, short sales and bankruptcies and which would be the possible solution. I would be glad to share that information with you.
This is certainly more difficult than an ordinary short sale, and, quite frankly, I do not think the banks will cooperate. There are some difficult nuances here that, in my opinion, require a discussion with a real estate attorney.