There are two primary laws pertaining to Short Sales and Foreclosure situations: 1) The Federal Debt Relief Act of 2007 and 2) CA's Senate Bill 458.
1) The Federal Debt Relief Act of 2007
The forgiveness of debt is typically considered income in the eyes of the IRS; however, the federal Mortgage Debt Relief Act of 2007 allows taxpayers to exclude income from the discharge of debt on their PRINCIPAL residence. This is set to expire 12/31/12 (which may once more get extended, but I would not take the risk). CA law is in line with the federal law (via SB 401 enacted April 12, 2010 and called the Conformity Act of 2010 covering January 1, 2009, and before January 1, 2013).
2) CA's Senate Bill 458
SB458 became law on 7/15/11. This law prevents a deficiency judgment after a short sale in most cases on ANY Trust Deeds on one-to-four residential units. You can read more about this law here:
"CA Senate Bill 458 Now Prohibits 1st/2nd Deficiency Judgments*"
Personally, I HIGHLY recommend you speak with both a RE Lawyer AND a CPA to jointly craft a course of action that considers how to reduce/remove your potential legal/financial exposure. This subject matter is not necessarily "black and white" regarding a â€œbest moveâ€.
Short Sale Lender approvals timelines are, â€¦shall we say, "getting better" but I would not delay a single day setting up your legal/tax planning meetings and then getting the property listed on market by a RealtorÂ® ASAP so you can close escrow before the end of 2012.