I sold a house in a short sale. The house had depreciate in value from 114,000 to 75,000. The house was sold for 82,000. The debt was canceled by the company for 32,000. The IRS now says was owe them 10,000 because the debt was canceled. We received no money on the sale of the home. Is there a way to get out of this?

No tax expert here, but logically, when the mortgage company cancelled the debt it was the same as giving you $29,000. IRS wants it's share of that gift. You should have shown a capital loss, either long term or short term. Did you file a capital loss form?

This is typical, you should have gotten a 1099 for the amount the bank forgave. The IRS considers this income to you

You will receive 1099-A from the lender. Check box 5. If it says that the borrower is personally liable for repayment then it is your income. If will reduce your cost basis. This may result in profit from the sale of the house.

If the property qualifies as your main home or second home, you can exclude gain of up to $250,000. For this you must meet Use test and Ownership test.
Read Your U.S. Tax Return: Profit From the Sale of Your Home (http://taxipay.blogspot.com/2008/03/profit-from-sale-of-your-home.html)

Even if you don't qualify for the exclusion and you have profit from the sale of the property, you may still not owe taxes. For this there is a recent (about 2 or 3 months back) change in tax laws about short sale properties.

Here is the information: Homeowners whose mortgage debt was partly or entirely forgiven during 2007 may be able to claim special tax relief by filling out newly-revised Form 982 and attaching it to their 2007 federal income tax return, according to the Internal Revenue Service
The new law contains important provisions for struggling homeowners.
Normally, debt forgiveness results in taxable income. But under the Mortgage Forgiveness Debt Relief Act of 2007, enacted Dec. 20, taxpayers may exclude debt forgiven on their principal residence if the balance of their loan was less than $2 million. The limit is $1 million for a married person filing a separate return. Details are on Form 982 and its instructions, available now on IRS web site.