750pts today. 450 tomorrow. Facing foreclosure/short sale

This is the worst case of poor judgement I have ever experienced. I am in a world of hurt, very concerned, and need advice. This is my first post. And I apologize - I type a lot.

Background:
My wife and I have always been very careful about credit. She is in her late 20s and I am 31 and our credit is at or around 750.

We have a couple of homes in our name in Illinois that we manage as rentals and an owner occupied in Oakland, CA. The price of homes here is shocking and makes monthly payments tolerable at best. It's not easy by any means. But we can make the payments without loosing sleep.

The problem:
We were introduced to a realtor who helped in facilitating the close on our home in Oakland. He and his wife became friends of ours after the deal. He was also an real estate investor (though not entirely successful at it). He lived a mile from us in Oakland, managed several local rental homes, two in Ohio, and two in Oregon.

He and his wife had a baby, became scared of gun shots that occurred near their home, and decided to relocate to Pleasanton, CA.

His credit was suffering slightly for one reason or another. He told us that it was because of his debt to income ratio and that lenders would not allow the purchase of another home.

He found a home in Pleasanton that was "too good to pass up". It allegedly had $100K in built in equity, best home on the block, and lots of potential. It was unlisted and the timing of the deal was crucial. His pitch was that we if he could purchase the home in the short term using our credit (put the home in our name) that he would be able to remedy his credit crisis and deed the home into his name within six months....

[OK, who can see where this is going]

While the market was still showing signs of life, we were able to secure an interest only loan for the entire $699K selling price.

Over a year has passed, we still own the home, and his credit was not improved. His source of income (selling homes, writing loans) trickled to a stop with the collapse of the market and lack of lending availability. He has become depressed and has not put any effort into his career and focuses all attention on coaching volleyball.

We are responsible for making the over $4K/mo payment. We rely on his money to do so. He has been 2-6w late giving us payment for almost a year. Things were getting scary. We were starting to feel as though the positive things he was telling us were not true.

And the atom bomb whistles overhead:
He has not paid us in over one month. We just got word yesterday that he dumped ALL of his personally owned properties into foreclosure. His credit basically does not exist at this point. He likely cannot afford this house either, and will never be able to purchase it.

If he decides to not pay anymore, he will put us into financial ruin.

If there is no money to pay for this home, which is the worst of the two evils - Foreclosure, or Short Sale?

The home is worth between $580K - $650K.
Our concern is the future impact this will have on our credit. Our quality of live depends on good credit when living in with the cost of living we do. We are facing a the maturing of an arm for our home in a few years and are concerned with what our payments will be at that time.

Is there anything we can do?

What are the realities of this situation regarding our credit?

What about the risks associated with a Short Sale? Will we be audited? Could the bank or IRS claim the rest of our property as collateral?

We are very concerned and a bit confused as this is a situation we have tried to stay FAR away from. I cannot believe this his happening. My wife (a Sr. Financial Analyst) is in tears daily over this.

Thank you for taking the time to read all of this.

Any help is greatly appreciated.