If you're considering short selling your property, you can do this on your own, but it's best to seek a law firm that has close ties to a real estate agent. The lender can still deny you a short sale, but the good news is you're not worried about a waiver of liability. However, you still need to consider tax laws and if this is your primary residence or a rental.
I agree with the other attorneys - don't wait. I'm a mediator in the Nevada Foreclosure Mediation Program (FMP) and there are new rules designed to help homeowners. I also represent homeowners and offer free consultations.
This answer is only for the federal taxes. The answer hinges on if this was ever your primary home for 2 of the last 5 years. If so, you should be able to not include this as income. If not, then this might be taxable income that you would need to treat as either short term or long term gains, depending on how long you held the property.
The very fact that she is under reporting the income could be considered a fraud tax by the IRS. The simple truth is that the IRS generally will never know about the under reporting, unless it is reported by another tax payer.
These are all great questions, but really can't be answered by any attorney outside your specific state. You should consider seeking help from a local attorney. Maybe call the state bar. It's clear to most that many lenders have acted improper during this mortgage crises, so you may have a good cause of action. Good luck!