What Is a Worthless Security & How to Report the Loss

An investment that loses its value can result in a worthless security, a financial instrument with no remaining worth and no possibility of future recovery. For tax purposes, this event allows an investor to claim a capital loss. This article explains the Internal Revenue Service (IRS) criteria for declaring a security worthless and details the process for reporting the associated loss on a tax return.

Establishing Worthlessness for Tax Purposes

A security is considered worthless for tax purposes only when its value is completely and permanently gone. A significant drop in price is not enough to meet the IRS standard, as the loss must be total with no reasonable expectation of future value. This requires the taxpayer to provide objective evidence that the investment is unrecoverable.

Certain identifiable events serve as the necessary proof of worthlessness. A company filing for Chapter 7 bankruptcy, which involves the liquidation of all assets, is a common trigger. This is distinct from a Chapter 11 bankruptcy, where a company reorganizes to continue operations. The complete cessation of business operations or a formal liquidation are also definitive events, as is a formal company statement declaring its securities worthless.

The rules for worthless securities apply to several types of investments. These include common and preferred stocks, stock rights, and various forms of corporate debt such as bonds, notes, and debentures. For any of these instruments, the taxpayer must demonstrate that a specific event has rendered the investment without value. For instance, if a company announces it is ceasing all business activities and dissolving the corporation, that announcement can serve as the identifiable event that establishes the security’s worthlessness.

The burden of proof rests on the taxpayer to pinpoint such an event. Without a clear, documentable trigger, the IRS may disallow the loss. Simply believing a stock will never recover is insufficient, as the worthlessness must be tied to a concrete occurrence.

Determining Your Loss and Claim Year

Before a loss can be claimed, a taxpayer must determine its amount and the specific year it can be claimed. The amount of the loss is calculated based on the security’s cost basis, which is the original purchase price plus any associated costs, such as commissions. Locating original brokerage statements or trade confirmations is necessary to establish this figure.

The loss must be claimed for the tax year in which the security actually becomes worthless, a date tied to the identifiable events. For example, if a company’s liquidation is finalized in December 2023, the loss must be claimed on the 2023 tax return. This timing is not elective, and failure to claim the loss in the correct year can lead to its disallowance. However, a special rule allows a taxpayer to file for a refund using an amended return within seven years from the original due date.

The IRS treats a worthless security as if it were sold on the last day of the calendar year it became worthless. This rule determines if the loss is short-term or long-term. If the security was held for one year or less before this deemed sale date, it is a short-term capital loss. If held for more than one year, it is a long-term capital loss.

Gathering comprehensive documentation is a preparatory step for claiming the loss. This includes records verifying the cost basis and evidence supporting the date of worthlessness. Proof can include court filings for a Chapter 7 bankruptcy or official corporate announcements. Having this information organized simplifies the tax filing process.

How to Report a Worthless Security Loss

The loss is reported on Form 8949, Sales and Other Dispositions of Capital Assets, which is used to detail each capital asset transaction. The information from Form 8949 is then summarized and carried over to Schedule D, Capital Gains and Losses.

When completing Form 8949, specific information must be entered in the corresponding columns for the worthless security. In column (a), provide a description of the security, such as the number of shares and the company name. Column (b) requires the original acquisition date, and column (c) is for the date of sale, which is always December 31 of the year it became worthless.

The proceeds from the transaction, entered in column (d), will be zero. Column (e) is for the cost basis. In column (f), the taxpayer should enter code “L” to indicate a worthless security. It is also a common practice to write “Worthless” across the final columns to clearly identify the nature of the disposition. This methodical entry ensures the transaction is properly recorded as a total loss.