THE INTERNAL REVENUE Code doesn’t authorize much relief for investors when they suffer capital losses that exceed their gains. It allows taxpayers each year to offset the excess against as much as $3,000 of their ordinary income from sources like salaries, pensions and withdrawals from IRAs.
What about the unused losses? The law lets investors carry forward such losses and claim them in an identical way on their tax returns in subsequent years, until they’re used up.
What if investors want to claim capital-loss deductions for stocks or bonds that become worthless because, say, the company involved goes bankrupt and the securities stop trading, so owners can’t even sell their holdings? Taxpayers have to satisfy several requirements.
They’re allowed to write off such losses only if their stocks or bonds become entirely worthless. Deductions aren’t available merely because their shares are no longer traded on markets and are practically worthless for all intents and purposes.
Let’s say an investor, whom I’ll call Polly, claims a loss that undergoes IRS scrutiny. She should be prepared to establish that there’s no current liquidating value, as well as no potential value.
The Stepford response of an adamant IRS: The lack of a ready market, or the decision of a company to file for bankruptcy, doesn’t mean her shares are worthless.
I caution Polly that it would be premature to uncork the bubbly just because she satisfies those stipulations. Next item on the agenda: timing. She can write off worthless shares only in the year they become worthless.
How is Polly supposed to determine the date she sustained her loss? It’s always the last day of the calendar year. This holds true even if the shares became wholly worthless at the start of the year.
My advice to Polly and anyone else who’s uncertain about the year of worthlessness: Nail down her deduction by claiming it for the first year in which she believes the stock becomes entirely worthless.
What if the IRS contends the loss isn’t allowable for the year she selected, because it wasn’t until a later year that the stock became worthless? She still has time to claim the loss in that year.
Contrast that with what could happen if Polly puts off claiming the loss until a later year and the IRS says worthlessness occurred in an earlier year. It may be too late for her to file a refund claim.
Indeed, the Second Circuit Court of Appeals in New York offered this advice: “The taxpayer is at times in a very difficult position in determining in what year to claim a loss. The only safe practice, we think, is to claim a loss for the earliest year when it may possibly be allowed and to review the claim in subsequent years if there is any reasonable chance of its being applicable for those years.”
Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator). His previous articles include Take a Break, Pay as You Go, It’s All Relative and Now or Later. Information about his books is available at JulianBlockTaxExpert.com. Follow Julian on Twitter @BlockJulian.