He could very well be telling the truth. He's saying that it will take at least $500,000 (or maybe $514,000) to pay off the mortgage, penalties, etc. OK, he could be stretching the truth. My gut sense, though, is that he's probably telling the truth.
How much is the house really worth? If it's worth $500,000 (or $514,000) and you want the house, pay it. It'll get you the house without you overpaying, and it'll solve a really big headache for the seller. If it isn't worth that, then offer no more than what the house is worth (say $486,000) and leave it at that. He can choose to attempt a short sale, or he can reject your offer. It's his choice.
But you really need to consider the comps and the true value of the house.
What does your Realtor say?