Documenting Nonbusiness Bad
Debts
and Worthless Securities
Although it’s presumably never the intention going in,
sometimes an investment does so poorly that it becomes completely
worthless. The same thing may happen to money advanced to a family
member or friend. While meant as a loan, the debt may at some point
become completely uncollectible. If either situation happens to you, the
tax rules can help ease the pain of the loss by allowing you to claim a
tax deduction—if you follow the rules. Here’s a summary of what it takes
to claim a loss.
Worthless Securities
A loss on a bad investment is deductible only when the
stock or other securities are completely worthless. Thus, a deduction is
not available as long as you own the security and it has any value at
all.
Worthlessness is typically established by showing an
identifiable event that demonstrates the security has no value. For
example, by itself, a corporation’s bankruptcy filing normally is not
sufficient evidence to prove that stock or other securities in the
company are worthless. However, if it becomes clear in the bankruptcy
proceedings that the creditors are going to end up with 100% of the
company, the corporation’s existing shareholders would own worthless
securities at that point (and could write off the basis of those
securities in the tax year that event occurs).
To avoid the issue of determining when a security
becomes worthless, it may be easier to just sell it if it has any
marketable value. As long as the sale is not to a close family member,
this allows you to claim a loss for the difference between your tax
basis and the proceeds (subject to the normal rules for capital losses
and the wash sale rules restricting the recognition of loss if the
security is repurchased within 30 days before or after the sale).
Nonbusiness Bad Debts
If you loan money to someone and do not get repaid, the
loss is treated as a short-term capital loss as long as the debt was
truly a loan and not a gift. To qualify as a loan, an advance must be
made with an expectation of getting repaid. It also helps if the loan is
reduced to writing, adequate interest is charged, security or collateral
is obtained, and demand for repayment is made once the loan is past due.
In other words, the more you treat the loan like a third-party lender
would treat it, the better chance you have of establishing the existence
of a bona fide debt (and thus a bad debt deduction if the loan isn’t
repaid).
Conclusion
Getting a tax deduction for a loan or investment gone
bad will not completely offset your loss, but it certainly does not
hurt. Thus, it is important that you comply with the tax rules that
allow the deduction. Should the need arise, we will be happy to explain
these rules to you in more detail or otherwise help you determine how to
salvage as much of a loss as possible.
Return to 2004 Tax Tips
