The "Mortgage Forgiveness Debt Relief Act" was signed December 2007. I am under the impression that signing Legislation into law through a Bill (signed by, as of today still President Bush ) with preclude the IRS from taxing individuals on debt forgiven by a Lender. I am not an attorney but I believe that Lenders might be issuing the 1099 in order to prove and deduct these losses from their Federal Tax Returns. In any event, Mr. or Mrs.Hwhiteside, check with the IRS or a Real Estate Attorney to be completely sure that you will not be taxed.
I understand that although this December 2008 (not 2007? right?) legislation passed, I believe that many lenders are still issuing 1099's for what is consider phantom income. That is the difference you describe is called. I had this conversation with a bank vice president a week ago and they are not issuing them in every case, but in many. I find it to be hugely inconsistent. So your question should be directed to your lender or your lender's asset manager for what they plan to do in your particular case. Then your second question is to a tax professional (someone who you use) about what they plan to do with a 1099 for phantom income if it's in fact issued to you. With all due respect to Katrina, this is not something that will be on the HUD-1 or disclosed by the agent. to the seller because they won't know the plans of the lending institution for a 1099. This is a decision by the lender taking the short sale.
So your question says "are we going to be taxed" and I am responding as if your question said "will we have to pay tax" because I think that's what you're asking. Please call me if you need additional help.
The IRS considers debt relief a taxable event, however, if you are insolvent or filing bankruptcy, you should not have to pay any tax. Save any forms you fill out , such as a financial statement, to show your status (for insolvency) at the time of the sale since your staqtus at the time of sale is the time to use for this. It is not based on when you may receive the tax bill. You can go to the http://www.irs.gov site to look up the insolvency definition.