If a company goes into bankruptcy, the stock can drop dramatically and often stops trading on the stock exchange. Generally, you have to sell a stock to claim a capital loss, so a bankrupt stock can cause problems. The Internal Revenue Service recognizes this difficulty and allows you to deduct stock losses due to bankruptcy. However, you must carefully document the stock's worthless status. Most brokerage firms also provide assistance in unloading bankrupt stocks.
Form 8949 is a worksheet you have to use when filing capital gains or losses with your taxes. The information you enter on Form 8949 ultimately gets entered on Schedule D and transferred to your Form 1040. To deduct a stock loss due to bankruptcy, enter the information regarding the stock on line 1 of Part 1 or line 3 of Part II, as you would with any other stock sale. Under the sales price column, enter "worthless." For tax purposes, you should enter the last trading day of the year as the sale date for a worthless security, according to Bankrate.com. Check the box indicating that this transaction was not included on Form 1099-B, which lists all regular stock transactions.
In the event of an audit, the IRS will want to know how you arrived at a valuation of "worthless" for your security. Bankrate.com suggests that you keep documentation of when the stock became worthless and how you made that determination. Anything that demonstrates the impossibility of that stock providing any return to investors will suffice. Examples include canceled stock certificates, evidence that the stock no longer trades on any stock market or the non-existence of the company should suffice. Some firms will allow you to sell worthless stock for penny in exchange for signing a "tax loss" letter. Since the letter shows that you have relinquished all interest in a stock, it is an easy way to document your loss. Obviously, if you do sell your stock lot for a penny, you should enter the actual price on your tax forms, rather than writing "worthless."
Once you have documented your loss, you can deduct your stock loss just like any other losing stock sale. Using Form 8949 and Schedule D, offset your gains and losses to determine your net capital gain or loss. If you show a net capital loss, the IRS allows you to offset an additional $3,000 of income. If you have a significant loss, you can carry that loss forward into future years, offsetting capital gains and $3,000 of income per year until your total loss is depleted.
While most bankrupt stock ends up worthless, it's possible that you will get new shares of stock when a company emerges from bankruptcy. While this is a rare occurrence, it's possible that the stock you thought was worthless when a company declared bankruptcy will actually find new life when the newly reorganized company comes out of bankruptcy. In this case, your stock will not be worthless. However, you can still sell it and deduct the loss if it sells below your original purchase price.
After receiving a Bachelor of Arts in English from UCLA, John Csiszar earned a Certified Financial Planner designation and served 18 years as an investment adviser. Csiszar has served as a technical writer for various financial firms and has extensive experience writing for online publications.