Yes, you may owe taxes. The amount of your mortgage forgiven by your lender to allow you to sell your house for less than you owe may be considered taxable income. Under the Federal Mortgage Debt Relief Act of 2007 that income is currently exempt from federal tax (up to certain limits), but the act expires at the end of 2012 and may not be extended. There is currently no similar exemption in Massachusetts, so that income may also be subject to state tax. You should consult with an accountant or a tax attorney to be certain you understand your tax liability before you agree to a short sale.
You or your realtor should try to negotiate removing your need to pay back any deficiency, which is the difference between what you owe minus what money the bank receives from your sale.
On the other hand, if you have other significant debt that you cannot pay and/or do not mind losing your home, you may wish to speak to a bankruptcy attorney who will be able to speak to you about declaring bankruptcy. Filing for bankruptcy will have a significant impact on your credit score, but so will not paying your other bills, mortgage, and going through with a short sale. Propety taxes are attached to the property and if you file Chapter 7 bankruptcy that will remove your personal responsibility to pay the property taxes and the deficiency on the mortgage. You will get a fresh start.
As for paying income taxes on amounts that bank will not be able to collect from you, I would speak to an accountant and a bankruptcy attorney about what forgiven debt will need to be reported as income on your future tax return.
The content of this answer should not be relied upon or used as a subsitute for consultation with professional advisors and it should be clearly understood that no attorney-client privilege has been created. A more complete answer and/or more accurate answer can only be provided in a more thorough examination of the facts in a consultation with my firm.
Your description does not contain sufficient facts to give you an answer. You may, or you may not, depending on a number of different facts, including things such as what your cost basis in the house is and what, and how much, your other debts are.
The only (partial) answer I can give at this point is that you are likely to have a deficiency of about $85,000 once this short sale closes. If all or a part of that deficiency is forgiven then the lender will report the forgiven amount to the IRS on a Form 1099 and you will be required to include the amount forgiven as taxable income unless you were insolvent in an amount greater than the amount forgiven at the time it was forgiven (this is merely an approximate summary of the test used under section 108 of the Internal Revenue Code to determine whether income from the forgiveness of debt may be excluded from taxable income).
Please do yourself a favor and talk to competent local tax counsel - either a tax attorney or an accountant/CPA - to get a proper answer to your questions, as well as assistance in figuring out how to deal with the consequences of this short sale.