Tax Returns Tax Deductions for Worthless Securities

Bad investment advice, recent economic troubles and poor stock market performance have resulted in many people losing a great deal of money on their investments. However there is some hope for a taxpayer suffering such misfortune. The taxpayer may be able to recoup some of the losses with the help of the federal tax code. The federal tax code may allow a taxpayer to take a tax deduction for securities (stocks and bonds) which are deemed worthless.

Definition of Securities

According to the tax code, securities or debt instruments that are offered for sale to the general public also include the following:

• Stocks and the right to purchase shares of certain stock
• Bonds
• Paper, notes or other instruments which signify a debt owed by a government or corporation.

Debt instruments or stocks not offered for sale to the public are not considered to be securities, such as are those issued privately by individuals.

Definition of "Worthless"

In order to take a deduction for worthless securities, the securities must be entirely worthless – they are worth nothing ($0.00). A taxpayer cannot take this tax deduction for securities or stocks which drop in value by a large amount but still retain some value. For example, 500 shares in XYZ Corporation are bought in 2008 for $10,000. If in 2009 the value of these shares fell to $1.00 per share, the taxpayer is not entitled to take this tax deduction for the loss in value of the shares because the shares of stock are not worthless – they are still worth something.

Proving the worthlessness of a taxpayer's securities is the sole responsibility of the taxpayer. In general, the taxpayer bears the burden to show that:

• the issuer of the securities (e.g., the corporation) does not have any value at all at the time the taxpayer is taking the tax deduction
• it is not expected that the securities are ever going to have any value in the future
• an identifiable event caused the corporation to become worthless, for example the corporate assets were embezzled by high level employees, all the corporate assets were sold or seized in order to pay off creditors, the corporation declared bankruptcy, etc.

If there is even the slightest chance that the securities of the taxpayer could have a value greater than zero, the taxpayer cannot claim the securities are worthless. For example, if the XYZ Corporation files for a Chapter 11 reorganization bankruptcy, it remains possible that an investor's stock will still retain some value throughout the bankruptcy period and can be sold, albeit at a significant discount. Alternatively, investors may be given new shares in the company once the bankruptcy period has been concluded with success. In either case, stock owned by an investor would not be considered to be worthless.

Abandonment of Worthless Securities

During 2008, new rules came into effect to help establish "worthlessness", which includes any securities that are abandoned by a taxpayer after March 12, 2008. Abandonment of securities means that the taxpayer has given up all rights to the securities without any value received and without any recourse. Such an act of abandonment means that even if the securities are not completely worthless, the taxpayer can still take a tax deduction since the taxpayer can expect to receive no value for the securities in the future.

Even with this new abandonment rule, it can be difficult to determine whether or not securities are worthless as there has not been sufficient activity under this rule to create consistent expectations. A taxpayer who is contemplating abandoning securities in order to take a deduction for worthless securities is highly advised to consult with an experienced tax attorney or a financial advisor before taking action.

Determining Tax Deductions for Worthless Securities

Securities held by investors are typically considered "capital assets" as they represent investments in order to make money. When these capital assets are sold, the seller will either have a "capital gain" (a profit) or a "capital loss" (a deficit) on this investment and this transaction will receive special tax treatment:

• A capital gain or loss is either "long term" or "short term". Long term refers to securities bought and held for at least one year or greater prior to the date of sale. Short term refers to securities sold after holding them for less than one year after purchase.
• Capital losses may be offset against capital gains. However the offset must first be applied against gains and losses of the same kind, such as long term losses being offset first against long term gains. If a taxpayer's capital losses are greater than the taxpayer's capital gains for the year (or if the taxpayer has no capital gains), up to $3,000 of long term capital losses may be offset against other income in any one tax year. If the taxpayer's capital losses amount to more than $3,000, the remainder is carried over into the next year.
• The tax rate for long term gains is much lower than tax rate for short term gains, the latter of which is taxed at the same rate as the taxpayers' highest income tax rate.

Worthless securities are recorded on Schedule D of the IRS Form 1040. Determining the deduction amount requires that the taxpayer calculate the taxpayer's "tax basis" in the worthless securities. The tax basis is usually the price paid for the securities plus the cost of any brokerage fees or other like expenses. In relation to the tax deduction, the worthless stock is considered to have been sold at a complete loss on the final day of the year that the stock or securities became worthless.

By way of example, in July 2008 a taxpayer purchased 500 shares in XYZ Corporation for $10,100 ($20 per share, plus $100 for brokerage fees). During April 2009, the securities became worthless. At the same time, the taxpayer also sold 2,000 shares in ABC Corporation for a long term capital gain of $6,000. The taxpayer can take the following tax treatment on the 2009 tax return:

• The worthless XYZ stock may be considered as a long term capital loss even though the XYZ stock was held for less than one year from the date of purchase. This is because according to the tax code, the worthless stock was considered sold at year end - a loss as of December 31, 2009. As such, it satisfies the one year and a day rule to qualify for long term capital loss treatment.
• The taxpayer's $6,000 long term capital gain on the sale of the ABC stock in April 2009 would be reduced to $0 because the taxpayer can apply $6,000 of the $10,100 loss resulting from the XYZ stock.
• The remainder of the loss suffered can be carried over to 2010 ($10,100 - $6,000 = $4,100). Any capital gains in 2010 can be offset by this amount.

Missing the Worthless Securities Tax Deduction Deadline

Due to the difficulty in determining when worthless security actually becomes worthless, a taxpayer can recover for losses even if they were not claimed in the year in which the securities became worthless. A claim for a tax refund or tax credit may be made by filing an amended tax return for the particular year in which the security became worthless. A taxpayer is given seven years to file this amended tax return from the date of the original tax return for the year in question or, if it is later, two years from the date that the taxpayer paid the taxes.