What to do when you’ve picked a ‘dog’

October 24, 2014

For the purpose of this column, let’s define a real dog or a dog as a worthless security, not my year old English Bulldog, Winnie. Hey, nobody’s perfect; nor is any company. From time to time, companies go belly up rendering their stocks and bonds worthless. Well, after you get over the emotional anguish of having picked a real loser or perhaps you inherited it, there are some tax benefits to explore.

We’ll assume, for now, that the security is worthless. This creates a capital loss. The loss is equal to your cost basis in the security. What is cost basis? Typically, it will be what you paid for the security or what it was worth when you inherited it. However, it is not always that simple.

If, for example, you bought additional shares by reinvesting dividends from a stock, your cost basis needs to be adjusted. Here’s how it works.

Assume you bought 100 shares of a stock for $1,000 last year and you reinvested the $100 of dividends distributed from the company. The next year, you received $200 in dividends and capital gains distributions, which you again reinvested. Since tax law considers these reinvested earnings as paid to you even though you didn’t actually have the cash in hand, your adjusted cost basis when the stock is sold should be recorded at $1,300, instead of the original purchase price of $1,000.

Thus, if the sale price is $1,500, the taxable gain would only be $200 ($1,500 – $1,300) instead of $500 ($1,500 – $1,000). If you record the cost basis as $1,000, you’ll end up paying more taxes than you have to. This gets even trickier with futures and other exotic investments, but enough on basis for now.

OK, we know what our basis is. The next thing to determine is whether or not this a short term or long-term capital loss? This is pretty simple. Short-term is one year or less. Long-term is more than one year. Capital losses offset capital gains dollar for dollar, so, the first thing you do is net out short-term gains and losses.

Long-term calculations are a little trickier. If long-term capital losses exceed long-term capital gains, the maximum deduction against other income (i.e. salary, interest, dividends, etc.) is $3,000 in any one year. Excess losses may be carried forward to future years.

This is a classic “Heads I win, tails you lose” from Uncle Sam. I have had some older clients say to me, “I won’t be around long enough to use up all of my losses.” Oh well, onward and upward.

There has probably been enough paper to stuff the Rocky Mountains created by worthless securities litigation. There are two critical issues: is the security truly worthless and when did it become worthless? Whether a stock is truly worthless involves consideration of both the present condition of the issuing company and the value the company may have in the future. A deduction is not permitted for partial worthlessness or decline in market value (unless the security is sold). In other words, worthless means truly worthless. Determining worthlessness is not an easy thing to do.

Generally, a stock is considered worthless in the year in which there is some identifiable event that demonstrates the worthlessness of the security. A bankruptcy proceeding in which it is determined that there will be no value for security holders is a classic example of such an identifiable event.

The reorganization of a business that wipes out the interest of one or more classes of investors also may qualify as an identifiable event. However, continued losses or the lack of a liquidation value may not be an event demonstrating worthlessness. Once the identifiable event occurs, the security is deemed to be worthless on the last day of that tax year.

Congress recognizes that determining when a security is truly worthless can be a tricky proposition. Instead of the normal 3-year statute of limitations that applies to amending returns, a special 7-year statute applies to amendments relating to worthless securities. The claim of a capital loss must occur in the year in which the identifiable event occurs. One court has suggested that to protect themselves, taxpayers should claim the earliest possible year and renew the claim if it appears that there’s a chance that it will be applicable to a future year.

And lastly, something for the little guy. A special rule applies to the stock of certain small corporations. Under these rules, up to $50,000 ($100,000 on a joint return) of basis may be deducted as an ordinary loss in the event the small business stock becomes worthless. This is a terrific deal–ordinary losses if you lose and capital gains if you win. However, there are numerous requirements to be met, including 1) the original capitalization of the company can be no more than $1 million, and 2) at least 50 percent of the gross receipts of the corporation for the last five years must have been from the active conduct of a trade or business.

Good hunting with your dogs!

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual. Randy Neumann, CFP® is a registered representative with and securities offered through LPL Financial. Member FINRA/SIPC. He can be reached at 600 East Crescent Avenue, Suite 104, Upper Saddle River, NJ 07458, 201-291-9000.