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.
But what about unused losses? Well, 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? To do this, taxpayers have to satisfy several requirements.
First, 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.
But 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 the deduction by claiming it for the first year in which you believe the stock became 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 earlier. 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.”
Another possible hurdle for Polly and anyone else who seeks to game the system is that IRS examiners allow a write-off for a loss on the sale of an investment only if she suffers a bona fide economic loss.
This long-standing tax rule was underscored in a decision by a federal appeals court.
David Fender was trustee for two trusts he had set up for his youngsters. During the year in question, the trusts had realized hefty capital gains. To offset these, Fender arranged for the trusts to sell tax-free municipals that had dropped in value. The trusts sold them to a bank in which Fender owned the largest single block of stock. The trusts repurchased the bonds 42 days later.
The appeals court held the loss on the sale should be disallowed; the transaction merely shuffled the bonds back and forth. The trusts had, therefore, not incurred a real economic loss. Fender, reasoned the court, “had sufficient influence over the bank to remove any substantial risk that the trusts would be unable to repurchase the bonds and thus eliminate the apparent loss on the sale to the bank.”
Among other things, noted a skeptical court, the bank didn’t normally purchase the type of bonds that it acquired from the trust. Another bank, where Fender lacked similar clout, refused to buy the bonds.
Nor was his case bolstered by the disclosure that the trusts allowed the sale proceeds to remain with the bank until the bonds were repurchased. The clincher was testimony by the bank’s president that the transaction was an accommodation to Fender and a repurchase agreement existed, although no time and price for the repurchase of the bonds were fixed.
Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 275 and counting).
About Julian Block
Attorney and author Julian Block is frequently quoted in the New York Times, Wall Street Journal, and the Washington Post. He has been cited as “a leading tax professional” (New York Times), an “accomplished writer on taxes” (Wall Street Journal), and “an authority on tax planning” (Financial Planning magazine). More information about his books can be found at julianblocktaxexpert.com.