5.32 Worthless Securities
If you owned stock or a bond as an investor (not as a securities dealer) that became completely worthless in 2012, you may deduct your cost basis for the security as a capital loss, subject to the deduction limit of $3,000 ($1,500 if married filing separately) in excess of capital gains (5.4). The worthless security is treated as sold on the last day of the year, which determines whether the loss is a short-term or long-term capital loss. Report the worthless security in the short-term or long-term section of Form 8949, as applicable (see below). Capital loss treatment applies unless ordinary loss treatment is available for worthless Section 1244 stock (30.13).
A loss of worthless securities is deductible only in the year the securities become completely worthless. If you abandon the securities, the securities are treated as completely worthless under an IRS regulation; see below. The loss may not be deducted in any other year. You may not claim a loss for a partially worthless security. However, if there is a market for it, sell the security and deduct the capital loss.
Because it is sometimes difficult to determine the year in which a security becomes completely worthless, the law allows you to file a refund claim within seven years from the due date of the return for the proper year (the year the security actually became completely worthless), or if later, within two years from the date you paid the tax for that year.
Filing Tip
To support a deduction for 2012, you must show:
If you are making payments on a negotiable note you used to buy the stock that became worthless and you are on the cash-basis method, your payments are deductible losses in the years the payments are made, rather than in the year the stock became worthless.
If the security is a bond, note, certificate, or other evidence of a debt incurred by a corporation, the loss is deducted as a capital loss, provided the obligation is in registered form or has attached interest coupons. A loss on a worthless corporate obligation is always deemed to have been sustained on the last day of the year, regardless of when the company failed during the year.
If the obligation is not issued with interest coupons or in registered form, or if it is issued by an individual, the loss is treated as a bad debt. If you received the obligation in a business transaction, the loss is fully deductible. You may also make a claim for a partially worthless business bad debt. If it is a nonbusiness debt, the loss is a capital loss and no claim may be made for partial worthlessness (5.33).
When to deduct worthless stock.
If at the end of 2012 a company is in financial trouble but you are not sure whether its condition is hopeless, it is advisable to claim the deduction for 2012 to protect your claim. If you claim the deduction for 2012 and it turns out that complete worthlessness did not occur until a later year, claim the deduction for the proper year and then file an amended return for 2012 to eliminate the deduction.
Planning Reminder
Another option in fixing the timing of your loss deduction is to abandon the securities, as discussed below.
Abandoned securities treated as worthless.
An IRS final regulation treats abandoned securities as totally worthless, effective for abandonments after March 12, 2008. To abandon a security, you must permanently surrender and relinquish all rights in the security and receive no payment in exchange for the security. The IRS will determine whether these tests have been met based on all the facts and circumstances. Under the general timing rule for worthless securities, the loss on abandonment is treated as resulting from a sale of a capital asset on the last day of the year in which the abandonment occurs.
Report a worthless security as a long-term or short-term loss on Form 8949.
If securities became worthless during 2012, they are treated as if they were sold on the last day of the year for purposes of determining your holding period, regardless of when worthlessness actually occurred. If a sale on the last day of the year provides you with a short-term (one year or less) holding period, report the loss as a short-term capital loss in Part I of Form 8949. Use Part II of Form 8949 for a long-term loss.
Ordinary loss on Small Business Investment Company (SBIC) stock.
On Form 4797, investors may take ordinary loss deductions for losses on the worthlessness or sale of SBIC stock. The loss may also be treated as a business loss for net operating loss purposes. However, a loss realized on a short sale of SBIC stock is deductible as a capital loss. A Small Business Investment Company is a company authorized to provide small businesses with equity capital. Do not confuse investments in these companies with investments in small business stock (Section 1244 stock) (30.13).
S corporation stock.
If an S corporation’s stock becomes worthless during the taxable year, the basis in the stock is adjusted for the stockholder’s share of corporate items of income, loss, and deductions before a deduction for worthlessness is claimed.
Bank deposit loss.
If you lose funds in a bank that becomes insolvent, you may claim the loss as a nonbusiness bad debt (5.33), a casualty loss (18.5), or in some cases, an investment expense (19.15). These options are discussed in Chapter 18 (18.5).