Another Arizona Dilemma. What to do?

[jwhip]

I purchased my home in AZ back in 2001 for $250K. We decided to sell our house in 2006 and move into a new house because there were too many bad memories attached with the house. These were related to my son who was going through a drug addiction at the time. My wife came to me and told me that she was ready to have a nervous breakdown and asked me if there was any way we could arrange it so that we would not have to do two moves. You see, if we sold the house then we would have to move somewhere until the new house was finished.

So we refinanced our home and pulled the money out we needed. The house appraised at $450K so I refinanced it for $360K and took cash out to put down on the new house. I refinanced it as owner occupied because I was still living there at the time. The lender talked me into a 5 yr fixed ARM where I would have the option of making 3 different payments. I could make the minimum payment, interest only payment or the full payment. My plan was to rent the house for a $$$ amount that would cover the minimum payment (this means that each month around $1K is tacked onto the loan balance). After a year I was planning on selling the house.

I lived in the house from 2001 until Dec 2007 and have had renters in there since then, which by the way are moving out at the end of Jul 09. I've read a lot on this board and would really appreciate any information you guys can give me. The house is currently worth around $240K which means I'm now about $140K underwater.

I'm trying to decide which avenue to pursue, whether that be a short-sale or just let the house go into foreclosure. I'm also trying to decide whether it would be beneficial for me to move back into the house again so that it would once again become my primary residence. But no matter which route I take, I'm concerned about the $140K difference.

1. The mortgage company is Aurora and I'm wanting to know if they will be able to come after me for the $140K?

2. Will the Mortgage Forgiveness Debt Relief Act apply to me? It seems as though it will because I've lived in the house and it appears to me that even after the law changes here in AZ in Sept, that I'll be ok.

3. How do I navigate through this mess so that I can protect myself from the mortgage company garnishing my wages or putting a lien against me as well as from the IRS so that they don't tax me on the $140 by counting it as income?

Your insight, thoughts and advice will be greatly appreciated!