When is a Loss Really a Loss?
Here are the two ways you can salvage some tax savings from unfortunate stock market forays:
Number 1: Trigger a capital loss deduction by selling the worthless shares. However, your write-off is limited to the amount of any capital gains for the year, plus $3,000 (or $1,500 if you use married filing separate status). After this, any leftover capital loss gets carried over to next year – subject to the same $3,000 (or $1,500 if you use married filing separate status)
Beware: Bankruptcy May Not Trigger Worthlessness
Unfortunately, relying on the worthlessness rule (Number 2) can be tricky. Here's why. You must correctly identify the year when the shares become totally worthless and then claim your write-off in that year and that year only. This sounds pretty simple, but sometimes it isn't. Why? Because the IRS doesn't consider your battered and bruised shares to be wholly worthless until it's clear that they have no liquidation value and there's no hope they will regain any value in the future.
Over the year, there have been many attempts to interpret this principle but the situation remains confusing. For example, the IRS has stated that bankruptcy proceedings don't necessarily establish complete worthlessness for a company's stock. (IRS Revenue Ruling 77-17) Why? Because shareholders are not always totally wiped out. There is some hope that the shares could become valuable again. Several court decisions have taken more taxpayer-friendly views of this issue, but they don't establish any firm guidelines.
This confusion is only made worse by the fact that shares of delisted bankrupt companies may continue to trade on the over-the-counter market (via a system called the "Pink Sheets") even after it is clear that shareholders will get nothing in the bankruptcy proceedings and the shares have been legally canceled. While this seems to make no sense, it happens.
Canceled share of a delisted bankrupt company may be trading for a few cents each (or a fraction of a cent) on the Pink Sheets market and still not qualify as worthless by some IRS auditors. Sticklers might disallow losses until all trading in the share has ceased. Who knows how long that might take?
Of course, the simplest solution is to sell any shares you believe will soon be worthless while they are still listed on the NYSE, NASDAQ, or American Stock Exchange. Taking this step has two big advantages:
- First, you'll net at least some cash. If you procrastinate, you may wind up with nothing.
- Second, selling the shares unequivocally triggers a tax loss. In contrast, if you hang on, you risk entering the Pink Sheet system for delisted stocks – where it's unclear if you can claim any loss until you actually sell. And if you don't sell, it could be a long wait before the stock becomes completely worthless in the eyes of the IRS and you qualify for a tax write-off.
If You Hang on, You Have Extra Time to Figure Out When to Claim a Loss
For whatever reason, you might decide to hold onto distressed shares until it becomes abundantly clear that they are indeed totally worthless. The Tax Code says you must claim your capital loss in the year when such total worthlessness occurs. For the reasons explained earlier, however, it's not always clear exactly which year that is.
Example: Let's say you claim a worthless stock loss on your 2008 return, which gets audited by the IRS in June of 2010. The auditor believes that the stock actually became worthless in 2006, so your 2008 loss is disallowed. Assume you filed your 2006 return on 4/15/07. Because the dis allowance occurs more than three years after the 4/15/07 filing date for your 2006 return, the three-year statute of limitations rule would normally prevent you from filing an amended 2006 tax return to claim your rightful worthless stock loss in that year and collect a tax refund. But keep reading...there's some good news that can save your situation.
A little-known exception on the tax law grants taxpayers a seven-year statute of limitations period – instead of the normal three years – to claim a worthless stock loss. Why? Because Congress recognizes that determining the proper year to claim a worthless stock loss can be problematic. So the special seven-year statute of limitations period gives you an extra four years to figure it out. Therefore, in 2010, you'll still have plenty of time to file an amended 2006 return to claim your rightful worthless stock loss for that year. (Source: Internal Revenue Code Section 6511(d)(1))
As you can see, there are potential problems with claiming worthless stock losses. Clearly, the best course of action is to sell distressed shares before they are delisted, trigger your capital loss, and move on while avoiding all the issues and hassles explained in this article. If you procrastinate and the stock becomes delisted, follow the tax filing advice above. Contact your tax advisor if you have questions or want more information.