My understanding is that if you are issued a 1099-C, the bank has, in fact, written off the debt. They cannot pursue you for the amount owed ("judgment of deficiency") AND write the debt off, which is what triggers the issuance of the 1099. You can only receive the 1099-C after the bank has thrown up it's hands and had told the IRS that your loan is a lost cause, permitting them to write off 35% of the loss...the bank has to issue the 1099-C to close their side of the deal with the IRS and it doesn't necessarily mean that you will be taxed on the income.
If the foreclosure was of your primary residence and you meet the requirements of the Mortgage Debt Relief Act of 2007, you will simply attach a form called a 982 and report the amount forgiven and will not pay tax on it.
If your lender's documentation of the inflated home value is making the case that the value of the home was higher than your balance and therefore you don't qualify for the Mortgage Debt Relief Act of 2007 then I think you would have to have the home's value amended, but talk to your tax adviser first about that as it may be irrelevant. In the recent foreclosures that I know of (a couple of close friends) this was pretty easy and painless and they had no tax liability nor was the bank able to come after them for the loss later.
I'm curious to know how the inflated value plays into the 1099-C calculation. If the home was sold at auction, the loss amount should be the difference between your payoff amount and the sale price. If it hasn't sold, then it should just be your payoff balance.
ETA: I assumed you had received a 1099-C. If you received a 1099-A, then it's a different ballgame as it does not mean that the lender has canceled the debt and you're correct, you have to use the 1099 info to calculate your your gain or loss. The gain or loss will be based on the smaller of the fair market value of the house or the outstanding loan balance, minus your basis (what you paid for the house). If the FMV is as low as you say it is, then your gain/loss should be a loss that would incur no tax liability. If the FMV that the bank reported is used, however, then you'd be working with the outstanding balance minus your basis and there would be a net gain that could potentially be taxable if you don't otherwise qualify for the appropriate exclusion. In this case, contact your tax professional immediately to find out what to do. In the foreclosures that I know of, all had FMVs lower than the outstanding loan balance so this wasn't an issue.
