Short selling "investment" property

Hey guys... here's the long/short of it. We bought a house 8 years ago. Re-fied and pulled $60k to remodel said house. We lived there for 5 years and when the market turned to crap we bought a nicer place with the intention of renting, then selling that place when the market came back. Now the market is worse than ever and the house is over $100k in the hole. All we really want to do is get rid of the house. We've got a short sale negotiated with the bank on the first and the second, having never stopped paying the mortgage.

Now the dilemma: My understanding is that the federal government will forgive the difference between what you owe and what you sell for if you've lived in the house for 2 of the last 5 years. By the time we got the house into escrow we were 1 month past that threshold.

What do we do here? My understanding is that we'll be taxed on the difference like it was income. Probably end up paying $30k plus in taxes on that. Because the loan adjusted down we are currently making a few hundred a month in rent on that house, but the bank wont fix the rate at the low interest we're currently getting. I expect that before the LTV comes back the interest rates will raise to the point that we're deeply in the hole on it every month. I hate owning a property that is in the red as a "investment". I'd much prefer to be done with it right now, but I'm not sure it makes sense. Income wise we're screwed. We make too much to depreciate the house or write off any part of it except some mortgage interest.

We could go the shiesty way and stop paying and keep collecting rent until the bank finally takes the house back. Then use the rent money to pay the IRS back on the taxes. If we're going to screw our credit we'd probably do the same to two houses we have that are underwater, but I'm nervous of being sewed. Fortunately or unfortunately we have a fair amount of money in 401k and the stock market that I'm not sure if they could come after or not.

Anybody been through any of this before and have any advise? I really just want to get on with our lives. We never really intended to hold onto this house. Just wanted to move up, but hold onto this until values came back and we could sell. 3 years later I'm still not seeing light at the end of that tunnel.

Maybe we should just clean out the investments. Take a few years off on vacation, dump all of our houses and start over. hahahaha! At this point I'm feeling screwed for trying to do the "right" thing and not just dumping the house years ago.