"We CANNOT live another 2 months like this let alone a year."
First off, of course you could live that way ... forever. I'm not saying you would or that you'd be comfy, but this sort of hyperbole is ... not productive.
It's also not clear why on Earth you'd even contemplate sitting around and waiting for a year or even months for this to be cleared up and for HUD to agree to proceed to closing (knowing it will get X less than it expected, because this lien must be satisfied before you and/or your lender will allow this sucker to close).
It's not your house until you go to closing, I'm afraid.
"... if we walk away we lose EVERYTHING..."
This doesn't compute. As for all of your money being tied up in an earnest money deposit, I hope not (always leave a cushion and a "stuff happens" fund -- if you don't have a substantial one of at least several months' worth of living expenses, you surely cannot afford to own a home, so this may be a blessing in disguise). I can't fathom that you'd want to do anything other than give written notice that you're terminating the contract and that HUD needs to agree in writing to whomever's holding the deposit to release it back to you.
If HUD won't agree to have the agent release your deposit after you've given written notice to them that you are canceling the deal, then I'd seek local real estate counsel.