Re: the 1099 part. You will get at least one and possibly two 1099s. One simply will document the sale price of the home and is used in the profit and loss calculation for Fed. income tax, real estate. The second 1099 would be for forgiven debt, which the IRS treats as ordinary income and taxes it as such.
The forgiven debt and deficiency are critical issues and you need an EXPERIENCED Realtor and attorney to save yourself from grief. The deficiency - the difference between what is owed and what the house sells for in a short-sale - is an important part of the negotiation, stressing that is is negotiable. IMHO, if there is no way around a deficiency, I would not do the short-sale. If a deficiency is demanded, it means you will have to pay it eventually, so what's the point? Of course, you could declare bankruptcy but that opens another can of worms.
Best thing you can do is get that realtor and attorney to negotiate a short-sale without a deficiency. I realize CA is a non-recourse state but I believe that only applies to primary mortgage to purchase a primary home: I may not be right on that, you need to check with a CA attorney. I don't believe a HELOC qualifies since it is unlikely it was used to purchase the home.
I'll say this, getting back to the 1099: you WANT to get a 1099 for forgiven debt because that, by definition, precludes the finance co. from coming after you for a deficiency - the debt was "forgiven."
As far as tax is concerned, yes, it is taxable unless it was for your primary home and depends what the HELOC was used for. IIRC, have to double check on the IRS site, the loan could have been for purchase or substantial improvement to that home (not 100% certain on the last part: that's used in some regulations but possibly not in others). However, if it qualifies, the Mortgage debt relief act of 2007 allows the tax to be waived, the qualifications are on the IRS site and form 982. Basically, primary home or if you were insolvent. Attorney and accountant needed if any of this is confusing.
