Please refer to the enclosed link which will give you some perspective on who and when a 1099-C has to be filed to report "potential" COD income. http://www.irs.gov/pub/irs-pdf/i1099ac.pdf.
The bottom line is that if the bank has taken the position to pursue the debt then it is not technically forgiven under state law and therefore not includable in your taxable income. The tax return should not report the income as the debt if not yet cancelled based on your presentation of facts. Moreover, even if the debt was cancelled then you can file Form 982 and perhaps eliminate or reduce the amount of COD income you are required to report to the extent you are technically insolvent. I suggest you confer with a local CPA or tax attorney to assist you in responding. Finally, your comment about bank w/drawing money would be inappropriate unless your mortgage was with same bank where you have your checking and savings where your loan agreement gave right of offset? (a question for you to please advise).
My answer is not intended to be giving legal advice and this topic can be a complex area where the advice of a licensed attorney in your State should be obtained.
Yes, that is true. The fact that the IRS is told about the fact that you have taxable income does not release you from the obligation to pay back the loan. Taxes have nothing to do with your obligation under state (contract) law. If you, in fact, pay it back you may get a deduction for what you repay in a later year.
The issue is an open one and certainly not simple.
I note that one bankruptcy court (in re Williams S. and Debbie E. Reed, 23 CBN 583, 2013 WL 2015984 (Bankr. E.D. Tenn 5/14/13) recently limited a creditor bank's claim because it had filed a 1099 C against the chapter 13 debtor.
Not sure if the California bankruptcy court in your decision has any relevant opinions. You may want to consult a local attorney. Chapter 13 can be a powerful tool for getting rid of this kind of behavior even if you don't intend to discharge any debt against your other creditors (100% plan).