If you're like many investors, you've lost money on some of your investments. It's not a hopeless situation, though. You may be able to recoup or recover some of your losses by taking a tax deduction for worthless securities.
Like many things in the tax code, though, there are special rules and restrictions on the deduction.
Under the tax code, securities include:
- Stocks, including stock options
- Notes, papers, or "debt instruments" for debts owed by a corporation or government
Securities don't include stocks or debt instruments that aren't offered to the public for purchase or sale, or those issued by individuals.
Securities Must Be Worthless
To qualify for the deduction, your securities must be completely worthless - worth $0. A drop in the market value of your stock or securities, even if it's big, doesn't qualify for the deduction because your stock still has value.
You have to show your securities are worthless, and that's not always easy to do. Generally, though, you have to show:
- The corporation that issued the securities has no value at the time you claim the deduction
- There's no reasonable expectation the corporation will have any value in the future
- Some "identifiable event" happened during the year in which the corporation became worthless that caused, established, or at least evidenced the worthlessness. An "event" can be many things, like bankruptcy or theft of all of the corporate assets
Again, if there's any chance the securities could have value, they're not worthless. For example, if ABC Company files Chapter 11 bankruptcy, your stock may still have value during or even after the bankruptcy.
Under rules that went into effect in 2008, worthless securities also include those you abandoned after March 12, 2008. To "abandon" a security, you have to give up all rights in the security and you can't take anything in exchange for it, like money or other stock. So, the new rules may make it easier for you to claim the deduction even when the stock isn't completely worthless.
Determining if your securities are worthless can be complicated. Talk to your tax lawyer or financial advisor to make certain that you're claiming the deduction at the right time.
Taking the Deduction
Most individuals hold securities as capital assets meaning they're held as investments - to make money. When you sell capital assets, you have capital gains and capital losses, which get special tax treatment. This can be complicated, but in general:
- Capital gains and losses are either long-term, meaning that you held the asset for at least one year and one day before you sold it; or short-term, where you held it for less than one year
- Capital losses are used first to offset capital gains of the same kind, so long-term losses off-set long-term gains. If you don't have any capital gains, or if your capital losses are more than capital gains, you can deduct the capital loss against your other income, up to $3,000 in any tax year. If your overall capital loss is more than $3,000, the excess carries over to the next year
- Long-term gains get taxed at a much lower rate (usually 0 to 15 percent for most taxpayers) than ordinary income, such as your salary, which can be as high as 35 percent. Short-term gains are taxed at your highest tax rate, just like your salary, up to 35 percent
You report worthless securities as a capital loss on Schedule D of your Form 1040. The amount of your deduction is your basis in the worthless securities. Generally, your basis is the purchase price of the securities, plus any brokerage fees. For purposes of the deduction, you're considered to have sold the worthless security at a loss on the last day of the year in which it becomes worthless.
For example: On June 1, 2009 you bought 1,000 shares of ABC Corp. for $10,050 ($10 per share, plus $50 brokerage commission). In March 2008, you can verify that the stock is worthless. Also in 2009, you sell 1,000 shares of XYZ Corp. for a long-term capital gain of $5,000. On your 2010 return, you can:
- Treat the worthless ABC stock as a long-term capital loss because, even though you held for it for less than one year at the time it became worthless, it's treated as a sale at a loss on December 31, 2009, and so the one-year-and-one-day rule is satisfied
- Reduce your long-term capital gain on the XYZ stock to $0 by applying the loss from the ABC stock. This will lower your amount of taxable income, and so it will lower the amount of taxes you may owe for 2010
- Carryover the remainder of the ABC worthless stock loss to 2009 ($10,050 - $5,000 = $5,050), which you can use as a long-term capital loss to offset your 2011 capital gains, if you have any
Did You Miss a Deduction?
Mainly because of the difficulty in establishing when exactly a security becomes worthless, you're given a chance to recover your loss if you don't claim the deduction in the year your securities become worthless.
You can file a claim for a credit or refund due to the loss by filing an amended tax return for the year the security became worthless. You have to file it within seven years from the date your original return for that year had to be filed, or two years from the date you paid the tax, whichever is later.
Questions for Your Attorney
- About a year ago I bought some stock when it was $25 per share. Today, it's worth $1.35 per share. For tax purposes, is it better for me to sell now and take a capital loss, or should I wait and see if the stock becomes completely worthless?
- Can I claim a deduction for worthless securities in my 401(k)?
- What can happen if the IRS doesn't agree that my stock is worthless?
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