This is sort of an advanced studies question that I hope none of you ever have to deal with. Prior to the Mortgage Debt Relief Act passed by Congress, folks whose homes were sold as short sale (or preforeclosure) were in for a nasty surprise on next year's taxes. (Short sale situations are a way to avoid foreclosure by striking a deal with the lender to sell your home at a loss to the bank, but at a less severe loss than a foreclosure situation would bring. While it's still a negative on your credit and your homebuying prospects in the short term, the financial effects are less severe than a traditional foreclosure.)
Before Congress enacted the new laws, the IRS would consider you liable for the amount of debt forgiven . . . wildly increasing your tax liability. In fact, if you completed a short sale in 2007, 2008 or 2009, you'll still get a tax liability statement from the lender. But now the IRS will exempt that "income" up to $1 million. Here's a handy article that gives some more detail:
http://www.adeltarealty.net/blog/real-estate-tips/buyer-tips/short-sales-income-tax-effect/