What it means
Section 165(g) of the Internal Revenue Code, published by Cornell's Legal Information Institute, covers worthless securities. If a security that is a capital asset becomes worthless during the tax year, the loss is treated as a loss from the sale or exchange of a capital asset on the last day of that year.
The statute defines a security for this purpose. It includes a share of stock in a corporation and a right to subscribe for or receive a share.
It also includes a bond, debenture, note, certificate or other evidence of indebtedness issued by a corporation or by a government or political subdivision, with interest coupons or in registered form. The IRS explains the practical rule.
If you own securities and they become totally worthless, you have a capital loss but not a deduction for bad debt. Worthless securities also include securities you abandon.
To abandon a security, you must permanently surrender and relinquish all rights in it and receive no consideration in exchange. The last-day rule matters for the holding period.
The IRS says you must work out the holding period to decide whether the capital loss is short term, which is one year or less, or long term, which is more than one year. The IRS says losses from worthless securities are reported on Part I or Part II of Form 8949.
The key fact is total worthlessness, so a stock that has only fallen sharply is not worthless. A security in an affiliated domestic corporation is not treated as a capital asset under the statute.
This entry explains the US federal rule as one example. Other countries have their own rules, and a taxpayer should check current IRS guidance and a tax adviser.
In practice
Real-world examples.
Example
A fictional investor owns shares in a company that is liquidated with nothing left for shareholders. The shares have no value at year end. The investor treats the loss as a capital loss from a sale on the last day of the tax year.
Example
A fictional investor holds a corporate bond issued by a company that has failed and will pay nothing. The bond is a security under the statute because it is a registered debt of a corporation. The loss is a capital loss, not a bad debt deduction.
Example
A fictional investor permanently gives up all rights in a worthless share and receives nothing. This counts as abandonment. The investor treats the share as worthless for the year of abandonment.
Formula
Calculation
Capital loss = cost basis - amount received.
For a security that is totally worthless, the amount received is zero, so the loss equals the basis.
Worked example with assumed figures: an investor bought 500 shares at $12 each and paid a $30 commission.
Basis = 500 x $12 + $30 = $6,030.
Loss = $6,030 - $0 = $6,030.
If the shares were held more than one year to the last day of the tax year, the loss is long term. If the investor had held them for 8 months to that date, it would be a short-term loss of the same amount.
Netting example: if the investor also has $10,000 of capital gains that year, the loss generally offsets the gain, leaving $10,000 - $6,030 = $3,970 of net gain. The figures are assumptions for illustration.Case study
Seen in the real world.
This case study is fictional and illustrative. An investor buys 500 shares of a small company for $6,030 including commission. Two years later the company is dissolved and shareholders receive nothing. The investor reviews the facts.
The shares have no remaining value, and there is no prospect of recovery. For the tax year the shares became worthless, the loss is treated as a sale on the last day of the year. Because the shares were held for more than a year, it is a long-term capital loss of $6,030. The investor reports it on Form 8949.
The investor keeps the purchase confirmation and the dissolution notice with the tax records. In the invented numbers, the investor also realised $10,000 of capital gains that year on an unrelated sale. The $6,030 loss offsets part of that gain, so the net capital gain is $3,970. A deep price drop in a different holding that still trades would not qualify, because the key fact is total worthlessness.
Watch out
Common mistakes.
- Treating a deep price drop as worthlessness, when the security must be totally worthless.
- Claiming a bad debt deduction instead of a capital loss for a worthless security.
- Ignoring the last-day rule, which sets the date for the holding period and the tax year of the loss.
Questions
People also ask.
What are worthless securities?
They are stocks, bonds or similar investments that have become totally worthless. In the US they are treated as capital assets sold on the last day of the tax year.
Is the loss a bad debt?
No. The IRS says that if securities become totally worthless you have a capital loss but not a deduction for bad debt.
How is the loss reported?
The IRS says losses from worthless securities are reported on Part I or Part II of Form 8949, depending on whether the loss is short or long term.
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