Insolvency

• You can claim insolvency if, immediately before your creditor canceled your debt, your total liabilities were greater than the fair market value of your total assets. If you're in the red $5,000 when your credit card company wipes out $2,700 in debt, you don't owe any tax. If the forgiven debt were $6,700, you'd owe tax on $1,700. IRS Publication 4681 has instructions and a worksheet for adding up your assets and liabilities, determining whether you're insolvent and figuring how much your debts outweigh your assets.
  
  

Assets

• If you want to declare insolvency, you have to treat everything you own as an asset. The IRS worksheet includes entries for cash and bank accounts; homes, vehicles; computers; household furnishings; tools; clothing; investments in a business; stocks and bonds; and books. You have to count assets even if you can't spend or sell them, such as your landlord's security deposit and the contents of your retirement account. If you own a house with a mortgage, you'd count the full value of the property, not just the equity.
  
  

Fair Market Value

• The fair market value of your assets is the price you and a buyer would agree on if you were both reasonably informed about the market and neither of you was under pressure to make the sale. You can determine the value of your bank balance and your IRA relatively easily, and you can value items you've just bought at the purchase price. If you own antiques or a car, however, you may need an appraisal, or at least a price guide, to determine the value.
  
  

Claiming Insolvency

• At the end of the tax year, your creditor should send you a 1099-C form stating the amount of the forgiven debt. Check the amount is accurate and that you don't qualify under any other exemptions: If your mortgage debt is canceled between 2007 and 2012, for example, federal law may exempt you from taxes on the debt. Use Form 982 to report the amount of the forgiven debt, the amount by which you're insolvent and any debt that will still be taxable.