San Diego Foreclosures For Sale – What Are Tax Implications On Cancellat’n Of Debt From Foreclosure/short Sale On Non-recourse Ca Loan 1yr Ago?

This beautiful San Diego home was purchased for $471,000 in Jun06, lived in for less than two years, loans (negative amortization 1st: about $410,000; and conventional fully amortized 2nd: about $94,000) both in California. The seller’s highest received offer is currently $360,000 (yes, a $111,000 (24%) drop in perceived value in just over a year). Sell is anticipating a large Cancellation of Debt income, as they owe so much more than they can conceivably get in a sale.
Incidentally, Seller had an offer for $448,000 just 3 months ago and never reported it to the bank because they were looking to get out of the loan on their own (without short sale), and were not even considering walking away/foreclosure at that time. Where is this market going?