If you negotiate with the creditor and all or part of the debt is forgiven or the debt would be canceled under bankruptcy protection procedure - you are sent the form 1099-C.
You are correct that the amount of debt forgiven is reportable on 1099-C - http://www.irs.gov/pub/irs-pdf/f1099c.pdf - generally is taxable, unless an insolvency exemption apply -- you should file a form 982 - to proof your insolvency - and might exclude all or part of canceled debt from taxable income.
The Mortgage Forgiveness Debt Relief Act of 2007 allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence. You still need to file the form 982 to claim the exclusion.
More information, including detailed examples can be found in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.
Let me know if you need any help.
Generally - you do not need to calculate the interest - the IRS will do that for you and will send you a bill.
The interest is constantly changed. Current interest is 4%.
You may view all interest rates here - http://www.taxalmanac.org/index.php/Federal_Underpayment_Interest_Rates
Here is an official IRS publication - http://www.irs.gov/pub/irs-pdf/n746.pdf
You do liable for penalties, but IRS may allows you to avoid tax penalties if you have a reasonable cause (good excuse).
Please see in this article the list of situations (with reference to the IRS documents) which may be used as a reasonable cause - http://www.mckenzielaw.com/IRSPENAL.html
Please also consider that the IRS has 10 years statue of limitation on collection - thus if the tax liability was assessed more than 10 years ago - it is unenforceable.
Tax Preparer
Taxes, Immigration, Labor Relations