I'm concerned that if I bring up the matter of withholding security deposit to cover the costs , they might cause more damage to the house prior to vacating this month. 

Make sure you take plenty of photos of every bit of damage if you decide to withhold anything from her security deposit aside from unpaid rent.

You will be responsible for factoring in the $12,500 penalty.The withholding from your $90,000 earning W-2 may be higher than that penalty resulting in a refund.

If I end up issuing this payment, do I also get the exiting tenant to fill out a w9 for their income or do we report this distribution as short term capital gains or do we withhold taxes.  

Owe nothing to anyone except to love one another; for he who loves his neighbor has fulfilled the law.Proverbs 3:27-28    Do not withhold good from those to whom it is due, When it is in your power to do it. 

If more, withhold the entire thing.

Many apartment managers are claiming they don't get paid for overtime, don't get Wage Earning Statements and they claim they are employees and not independent contractors meaning they sue you for filing them as Exempt from paying taxes when you should be withholding taxes from their earning, matching their payroll taxes and paying into social security, medicare, etc..

State that you will not be satisfied until your complete deposit is returned and you will seek the maximum permited by law for unlawfully withholding the security deposit..  

In many states, even more landlord friendly states, you must give written notice of the amount you're withholding from the security deposit, and why it is being withheld.

We are done with another flip.http://www.7156emeraldave.com/Escrow company is withholding Cal Firpta Withholding 3.33% Franchise Tax Board.