This might be old real estate news, but I'm repeating here because it's so important. However, please keep in mind that you should always consult your tax professional before you take my word here regarding your specific tax situation. So that being said, as you've probably already been told, the IRS does not tax you on the difference in your principal for forgiven mortgage debt either through your short sale or a loan modification. You might still receive a 1099 showing that the loan company has reported it and you do have to report it on your taxes.
However, California state laws still require you to pay taxes on the difference, and it is definitely something to keep in mind not just at tax time but also during the process of applying for a loan modification. It's a sad situation that when you're already stretched that you have to consider that the state still requires taxes, but at least it might help to know that beforehand.
This is how the California Association of Realtors reported it:
Governor Schwarzenegger vetoed a bill that would have prevented California homeowners who sold their homes via short sales or received loan modifications in 2009 from being taxed on the forgiven mortgage debt. Schwarzenegger vetoed the bill, which would have aligned much of the state’s tax code with that of the federal government’s, because it contained an unrelated provision regarding tax refunds for the state’s largest businesses. Although the governor vetoed this particular bill, he expressed his support for banning taxation of forgiven mortgage debt, and immediately called for the legislature to send him a bill to provide tax forgiveness prior to the April 15 tax-filing deadline.
So be sure to go over your financial situation with a fine-toothed comb before making at decisions.