Sometimes, investments don’t just go bad, they go really bad. For example, that highly touted hi-tech start-up you bought stock in a mere year ago ends up going out of business. Losing money is never fun, but you may be able to offset some of your losses in disastrous investments by taking a tax deduction for worthless securities. Be aware, however, that this is a complex and tricky deduction. You may need the help of a tax professional to guide you through it.
What Are Securities?
For purposes of the worthless securities deductions, securities include:
- stocks, including stock options
- bonds, and
- notes, commercial paper, 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.
When Are Securities Worthless?
To qualify for the worthless securities deduction, your stock, bond, or other security must be completely worthless. This means that it is worth nothing. A mere drop in the market value of stock or securities, even if it's big, doesn't qualify for the deduction. For example, you won’t qualify for the deduction if a stock you bought for $100 per share is now worth 25 cents per share—the stock is not worthless. Rather, the securities must be worth nothing and there must be no reasonable expectation they will have any value in the future.
To establish that securities are worthless, you usually have to be able to point to a specific identifiable event that caused, established, or at least evidenced the worthlessness. For example:
- the company has stopped doing business
- the company is insolvent—that is, its assets are worth less than its debts
- the company’s assets have been liquidated (sold), or
- the company has filed for bankruptcy or a bankruptcy receiver was appointed.
However, if there's any chance the securities could have value, they're not worthless. Even if a corporation in which you’ve invested files Chapter 11 bankruptcy, your stock could still have value during or after the bankruptcy. Thus, a bankruptcy filing may not in itself be sufficient to establish worthlessness.
Your stockbroker may be willing to send you a letter stating that securities have become worthless; or it may agree to buy them back from you for a nominal amount. If the securities are worth no more than, or less than, the sales commission your broker charges, many tax advisers would treat them as worthless.
Under rules that went into effect in 2008, worthless securities also include those you abandon 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. You need to make sure the security is removed from your brokerage or other account. The abandonment rule can make it easier for you to claim the deduction.
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.
How to Take the Worthless Securities Deduction
Unless you’re a professional stock trader, the stocks, bonds, and other securities you own as an individual are classified as capital assets for tax purposes. 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, if 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 offset long-term gains. If you don't have any capital gains, or if your capital losses are more than your 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 favorable tax treatment because they are taxed at a much lower rate than ordinary income, such as your salary. For most taxpayers, the long-term capital gains tax rate is 15%. However, taxpayers with low or modest incomes pay 0%, while those with large incomes pay 20%. In contrast, ordinary income is taxed up to a 39.6% rate.
You report worthless securities as a capital loss on Form 8949, Sales and Other Dispositions of Capital Assets, and then transfer the loss to 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 for nothing on the last day of the year in which it becomes worthless.
Example: On June 1, 2016 you bought 1,000 shares of ABC Corp. for $10,050 ($10 per share, plus $50 brokerage commission). In March 2017, you can verify that the stock is worthless. Also in 2017, you sell 1,000 shares of XYZ Corp. for a long-term capital gain of $5,000. On your 2017 return, you can:
- treat the worthless ABC stock as a $10,050 long-term capital loss. Even though you held for the stock for less than one year as of the date it became worthless, it's treated as having been sold for nothing on December 31, 2017. This way the one year holding period for long-term capital gains treatment is satisfied.
- reduce your long-term capital gain on your sale of the XYZ stock to $0 by deducting $5,000 of the loss from the ABC stock from your $5,000 profit on the XYZ stock. This will lower your 2017 income by $5,000, and thereby lower your 2017 taxes.
- deduct $3,000 of your remaining $5,050 loss from the ABC stock from your ordinary income—for example, income from your job or business.
- carryover the remaining $2,050 of the ABC worthless stock loss to 2018, which you can use as a long-term capital loss to offset your 2018 capital gains, if you have any, or deduct from your ordinary income if you don’t.
Did You Miss a Deduction?
Because of the difficulty in establishing exactly when a security becomes worthless, the IRS gives you an especially long time to claim this deduction. If you don’t claim the deduction in the year your securities become worthless, you have up to seven years from the due date of your return for that year to claim the deduction by filing an amended tax return for the year. This will give you a credit or refund due to the loss.
However, to ensure that the statue of limitations on claiming the worthless securities deduction doesn’t run out, it is always wise to claim the deduction as soon as you can. If it turns out you claimed the deduction prematurely, you can always amend your return for that year to eliminate the deduction.
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 IRA or 401(k)?
- What happens if the IRS doesn't agree that my stock is worthless?