A security (stock or bond) that becomes worthless during the tax year is treated as if it had been sold on the last day of the tax year.
If it is a capital asset, the resulting loss is usually a capital loss that is subject to various limits.
Capital losses first offset capital gains (both long-term and short-term) including the capital gain distributions from various mutual funds. And if that does not use all of the losses, then $3,000 can be a deduction on page 1 of form 1040 (U.S. Individual Income Tax Return) with the excess carried over to future years.
The amount of the loss is your adjusted tax basis in the security, your cost.
A security becomes totally worthless when it has no value or potential value as the result of an identifiable event. Sometimes a stockbroker will write you a letter that says the stock has no value. To abandon or give up a security, you need to permanently surrender and relinquish all rights in the security and receive no consideration.
Deductions are partial worthlessness are generally not allowed. However, like all tax rules, there are exceptions.
A special rule applies for stock that qualifies as Section 1244 stock. That must have been issued to you in exchange for money or property by the corporation that is a small business corporation (usually an operating company that has more than 50 percent of its gross receipts from other than royalties, rents, dividends, interest and annuities). Section 1244 stock gives ordinary loss of up to $50,000 for an individual or up to $100,000 of deductions for a joint return. If you think you may have Section 1244 stock that is worthless, be sure to see if your stock meets the requirements.
A capital loss is a long-term capital loss if the investment was owned for more than 12 months.
A worthless debt that does not meet the definition of a security (because it was not issued by a corporation or government) is treated as a bad debt. Business bad debts can be claimed as an ordinary loss when it becomes worthless entirely or in part. Special rules apply, but if the accrual basis of accounting is used, it can be deducted from gross income as an ordinary loss.
Non-business bad debts are deductible only as a short-term capital loss and must be totally worthless.
Don’t overlook the possibility of a deduction for worthless securities or bad debts.
Did you hear? “If I could wish for my life to be perfect, it would be tempting, but I would have to decline, for life would no longer teach me anything.” — Allyson Jones.
John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Company CPAs.