Introduction
Lately, the stock markets have been battered by news of recession, low earnings, unemployment numbers, negative leading indicators, and other bad economic news. This has lead to substantial capital losses for most investors across the investment spectrum. Those holding industrial stocks, financial stocks, transportation, and energy stocks are reporting their portfolio values have been cut essentially in half. Some holders of retail and financial stocks have seen individual stocks go from being stocks of respectable value to being worthless or near worthless.
Unfortunately, a lot of value has been lost by many investors. Fortunately, tax benefits abound when misfortune strikes. A stock that has been battered in value or has become worthless still contains value for those holding the stock. The value comes in the form of a tax deduction.
Netting
Fortunately, for investors any capital losses are first netted against capital gains. Capital gains may be few and far between right now, but for those holding appreciated capital assets such as that rare stock that is up right now, metals, and the like, it may be the best time to sell, take the gains and recognize an equal amount of loss to offset the gains. The end result is a zero tax bill.
For example, if an investor owns something such as farmland purchased during the 1980’s, as of right now, the property will be substantially appreciated. If the investor holds stock containing losses, the same investor can sell the farmland at a large gain and net that gain against the losses on the stock. Potentially, a farm owner can take a million dollar gain and walk away owing nothing in taxes when netting the two transactions.
Annual Limit
Despite the potential for large losses in the multi-million dollar range, there is a limit to which individual investors can deduct capital losses if no gains exist to net the losses against. The deduction is limited to $3,000 per year. The $3,000 loss can be deducted against income and capital gains.
This means any losses, potentially millions of dollars in losses, must be used over the course of many years in the future against capital gains. In some instances, the losses are so great that any perceivable human life span of capital loss deductions will not exhaust the potential losses some investors have endured. This is why timing capital losses against gains is critical, otherwise you could potentially have unused losses for the rest of your life.
Worthless Stock
The Internal Revenue Code permits deductions for stock which becomes completely worthless during the year. Stock is deemed to have been sold on the last day of the tax year for which its value has gone to zero. For stock to be worthless within the strict definition of the Internal Revenue Code, its value must be zero. As a practical matter, many stock’s value has gone to a price of a penny or two a share. A well known example of this is Circuit City. According to the definition, the stock may not qualify strictly as worthless stock, but for most practical reasons, stock of companies that have filed for bankruptcy may be in fact, worthless for deduction purposes. To be worthless in a practical sense, the company must be in a circumstance where the company and its stock will not recover, the liabilities must exceed asset value, the business must be in cessation, or a reasonable financial statement analysis would reveal no hope of ever being solvent.
Finally, if your stock has reached a point where it is beyond hope, you can sell the stock for pennies. Selling the stock will define the transaction as a stock loss and you will escape the gravity of the slippery definition of “worthless stock”.
Conclusion
The stock markets have seen their share of losses this year and the previous year. Exercising your losses for tax deductions can lessen the impact on your finances. Timing is critical in that you cannot deduct losses of greater than $3,000 per year in excess of your gains. Holding stocks until the losses are deductible is one way to time losses in your favor. The Center routinely advises people on matters involving capital gains and losses and the tax ramifications, business valuation, and business succession matters. For an analysis of your situation, contact the specialists at the Center for more information.
By: Dr. Bart Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors