> i am on a 5 year F2 visa since dec 2004.
Will you be getting a degree? If yes, you might want to get yourself an OPT work permit. That way, you are less likely to get bitten by the H1b quota issues.
> i am applying for residency starting july 2006.i will be finishing step 3 by
> jan 2006.
This should work, at least time-wise. It takes a couple of weeks to get the step3 result but you should be still in time to get your H1b with regular processing. (you can upgrade to premium later if you have to).
> is it easy going on H 1 from F 2?
Have you ever heard about anything easy as it relates to USCIS ??
> is there any special paperwork i need to do?
The employer has to file I129 (and a 'Labor Condition Application'), and you have to file a 'change of nonimmigrant status' request. Not aware of any 'special' paperwork. Of course, once your I129 is approved you could also leave the country and re-enter, depending on where you are from this might be the solution with less hassle and waiting times.
Good luck finding a residency on H1b. Tread lightly when discussing this issue with residency directors (even better, don't bring it up at all). Many hospitals are to cheap and too skiddish to file H1bs for their residents (they fear that by defining you as 'worker', they loose the right to work you into the ground for >100hrs/week)