Sorry for your difficulties. This is too common these days.
If this property is your main home, then the Mortgage Forgiveness Act will prevent taxes on any forgiveness of debt (as long as the transaction is completed by 12/31/2012.)
You are smart to try and avoid foreclosure. Your credit rating will be better if you do.
If this property is a second home or rental, let me know the specifics (cost basis, loan amounts, depreciation taken, etc.).
So would you suggest a deed in lieu or short sale?
They are both very similar except with a short sale, the deed is never transferred to the lender. In both cases, you need to make sure the lender is going to forgive any deficiency balance on the loan. The choice to accept a short sale or deed in lieu will be the lenders. I hope they will work with you.