A loss on worthless securities occurs when a stock, bond, or other security becomes completely worthless (i.e., has no market value) during the tax year. This loss can be claimed as a capital loss for tax purposes.
Key Rules (IRS Guidelines)
1. When to Claim the Loss
ü The loss is deductible only in the year the security becomes worthless.
ü You cannot claim a loss if the security still has some value (even if minimal).
2. How to Report
ü Report on Form 8949 (Sales and Other Dispositions of Capital Assets).
ü Enter "Worthless" in the description column.
ü Attach a statement explaining the circumstances (e.g., bankruptcy filing, liquidation).
3. Statute of Limitations
ü The IRS has 7 years (instead of the usual 3) to audit a return claiming a worthless security loss.
4. Ordinary Loss vs. Capital Loss
ü Most securities (stocks, bonds) → Capital loss (subject to $3,000 annual deduction limit against ordinary income).
ü Small business stock (Section 1244 stock) → Ordinary loss (up to $50,000 single / $100,000 joint).
5. Proof Required
ü Documentation showing the security became worthless (e.g., bankruptcy filings, corporate dissolution records).
Example Scenario
ü You own stock in XYZ Corp, which files for bankruptcy in 2025 and ceases operations.
ü The stock is deemed worthless in 2025.
ü You report the loss on your 2025 tax return as a capital loss.
Key Takeaways for Exam
✅ Deductible only in the year of worthlessness (not when you sell or abandon it).
✅ 7-year audit window (longer than the usual 3 years).
✅ Form 8949 + explanation required (not just Schedule D).
✅ Section 1244 stock allows ordinary loss treatment (better tax benefit).