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 might 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 might 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's 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.
But if there's any chance the securities could have value, they're not worthless. Even if a corporation in which you’ve invested files for Chapter 11 bankruptcy, your stock could still have value during or after the bankruptcy. So, a bankruptcy filing might not in itself be sufficient to establish worthlessness.
Your stockbroker could be willing to send you a letter stating that securities have become worthless, or it might 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 37% rate.
You report worthless securities as a capital loss on Form 8949, Sales and Other Dispositions of Capital Assets. Complete Part I or Part II of the form, whichever applies. Indicate you're claiming a worthless security deduction by writing "worthless" in the applicable column of Form 8949. You 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.
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 statute 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.