Watching your investments plummet in value is never fun, but if things get really bad and you wind up holding worthless stock, you can at least realize a tax break. However, to get that break, the stock has to really be worthless -- meaning that it has no value and no prospect of ever recovering any value.
Deduction vs. Capital Loss
The tax break for worthless stocks isn't technically a tax deduction. A deduction is an expense that reduces your taxable income. Instead, worthless stock counts as a "capital loss," meaning a loss of value in an asset between the time you bought it and the time you disposed of it. You can use capital losses to offset capital gains, reducing your tax burden. Any losses not used to offset capital gains can then be used to offset other income -- the same ultimate effect as a deduction.
Neither U.S. tax law nor the Code of Federal Regulations provides a concrete definition for the point at which a stock becomes "worthless," which allows the matter to be handled on a case-by-case basis. In general, though, taxpayers should be prepared to demonstrate that the stock has lost all its value and that there is no reasonable chance that the stock will recover. Just because a stock has lost most of its value, or the company is in bankruptcy, doesn't make the stock worthless. If the stock is still trading, even for pennies a share, the Internal Revenue Service will likely view it as having value. In such cases, if you want to take a capital loss on the stock, you'll have to actually sell it. But if you can show that the stock no longer trades on any exchange or that the shares have been canceled, you can claim the shares as worthless.
Claiming the Loss
To claim a capital loss, you must file Form 8949 and Schedule D with your tax return. When filling out these forms, treat losses from worthless stock as if you had sold the stock for zero dollars on the last day of the tax year. On Form 8949, you list all your individual capital gains and losses for the year. The December 31 "sale" date will determine whether you identify the capital loss on Form 8949 as a short-term loss, meaning you held the stock for a year or less, or a long-term loss, meaning you held the stock for more than a year. In the space under "Sale Price" for the worthless stock, write "WORTHLESS." On Schedule D, add up the data from Form 8949 and determine the impact on your taxes. The forms will guide you in what information you include on your return and where.
Carrying Losses Forward
While you can use capital losses not used to offset your capital gains to offset other income, you can apply only $3,000 worth of losses in any year. For example, say that you had $10,000 in capital losses from a worthless stock, plus $6,000 in taxable capital gains from other investments. You can use $6,000 worth of your losses to completely wipe out your capital gains for the year. You now have $4,000 left over. You can use $3,000 of that to offset income from your job or other sources. The remaining $1,000 can be "carried forward" to the next year, and used to offset that's year's income. If you had $8,000 of "extra" capital losses, you could carry forward $3,000 to the next year, then $3,000 for the year after that, and then the remaining $2,000 to the year after that.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.