Tax planning and compliance for investors
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By Kaye A. Thomas
Updated February 10, 2009
All stock pickers make mistakes, and sooner or later they make a really big one, investing in a stock that becomes completely worthless.
As a general rule, you can't claim a loss on a stock investment until you sell the shares. What happens if the stock becomes completely worthless, so that a sale is no longer possible? The answer is that you're allowed to claim the loss in the year the stock became worthless — but only under a strict rule that poses problems for many taxpayers.
The rule described here is for worthless securities, a term that includes bonds as well as shares of stock.
There are two big problems with the rule for worthless securities. One is that you can be stuck in a situation where the investment has no value to you, but it doesn't qualify as a worthless security under the tax law. You don't want it and you can't sell it. You're left singing the Dan Hicks classic, How Can I Miss You When You Won't Go Away.
What's more, the way this rule works, it can be difficult to determine when the deduction is allowed. If you claim it too soon, the IRS can disallow the deduction. But the same is true if you wait too long. It's like the riddle of the Sphinx: answer incorrectly and you face dire consequences.
That's why nearly worthless stock can be worse than worthless. You know your money is down the drain, but you may have a long wait before you can claim a deduction. On top of that, you have the hassle of trying to figure out exactly when the deduction is allowed, and the risk that the IRS will disagree with your judgment.
As with many of life's troubles, the best way out of this situation is to avoid getting in it. When you see one of your investments take a major hit, the tendency is to think you can recover your loss by holding on. More often than not, the best recovery available is the tax deduction you can establish by selling the stock.
You can't claim a loss for worthless stock that was held in your IRA. The same goes for stock held in your 401k account. In these accounts you don't have to pay tax when you have a gain, so you don't get to claim a deduction when you have a loss.
If the loss occurs in a custodial account for a minor child (sometimes called an UTMA or UGMA account), a deduction may be allowed, but it has to be reported on the minor's tax return. Often the minor has little or no income, so the deduction doesn't do any good. Nevertheless, it simply isn't possible for a parent or other adult to claim this loss: it belongs to the child.
You can't claim a loss for stock until it's worthless. Completely worthless. And this is the heart of the problem.
A stock that's in serious enough trouble will fail to meet the requirements for trading on a stock exchange. It will be delisted, which means you can no longer sell these shares in a normal transaction. For a period of time, though, it's likely that speculators will be willing to purchase shares at some dirt-cheap price, hoping they'll end up having at least a little value. Bids for these shares may be available through a quotation system known as the pink sheets. As a result, your shares are not completely worthless. They're just nearly worthless.
If you're in this situation, you may be able to establish your loss by selling the shares for a nominal amount. Even if there are no buyers, your broker may be willing to purchase the shares for a dollar. Too often, though, the cost of selling the shares is greater than the amount you can receive in a sale, and in some cases there isn't any practical way at all to make a sale. You're left in a kind of tax purgatory where you can't claim the loss until it finally becomes clear that the value of the shares has fallen all the way to zero.
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