Taxpayers are allowed a capital loss tax deduction when securities (e.g., common stocks) that are held as capital assets become worthless. The issue of worthlessness can occur where, for example, a taxpayer owns an interest in a small, closely held corporation that is experiencing severe financial problems. But, when is a security actually worthless? The IRS says the loss can be taken only when the security becomes wholly worthless; losses for partial worthlessness cannot be claimed. This rule also requires that a taxpayer correctly identify the year a security becomes wholly worthless.
This is important because you can offset capital gains with capital losses, including losses from worthless securities. To the extent there are excess capital losses, up to $3,000 ($1,500 for married filing separate returns) can be deducted against your ordinary income. Remaining capital losses can be carried forward indefinitely.
The question of when a security becomes worthless has been the subject of many court cases and IRS rulings. For example, simply because a corporation declares bankruptcy, its shareholders may not be able to claim a loss when it is possible that they will obtain stock in a corporate reorganization. Worthlessness depends on the particular facts of each situation. Generally, a security is considered worthless at the time it first has no liquidation value, and no reasonable hope or expectation exists that the security will become valuable at some future date. A taxpayer may be able to establish worthlessness by showing a fixed and identifiable event demonstrating the worthlessness of the security.
Example: Timing of worthless stock loss. Valerie bought 200 shares of ABC Corp. for $15 per share in 2003. ABC is a publicly traded company. As of the end of 2007, the stock price had declined to $1.50 per share, and the company was in Chapter 11 bankruptcy. Valerie cannot take a worthless stock deduction in 2007 for her anticipated loss on ABC stock because the stock is not wholly worthless – as evidenced by its trading value. To establish a deductible capital loss, Valerie must sell her shares or wait for an event that renders her stock worthless. Even if her ownership interest is significantly diluted in the Chapter 11 reorganization, Valerie will be unable to claim a loss as long as she holds securities that have some value – however nominal. If, however, ABC is liquidated in bankruptcy, Valerie should be able to claim a worthless security loss when it is established that her equity holder class will receive nothing in liquidation.
As noted above, it is often difficult to determine if and when a security is wholly worthless. However, the IRS recently issued a final regulation pertaining to abandoned securities which may help in making this determination. The new regulation seems to indicate that a worthless security deduction is available when the taxpayer merely abandons it, even if it has not become wholly worthless. In effect, the worthless securities deduction is available to the taxpayer because, as a result of abandonment, the security is wholly and irretrievably worthless. To prevent abuse of this privilege, the IRS requires a taxpayer to permanently relinquish all title to the security and receive no consideration for it. This is obviously a tough issue to understand and evaluate. So, please contact us if you have questions pertaining to securities with minimal or no value. We can help determine the most tax-wise and credible way to proceed in the determination of worthlessness or abandonment of investment securities.
