Your clients, who are ordinary investors, still hold substantial positions in Lehman Brothers and Fannie Mae stock in their portfolio and are wondering what they should do to claim a tax loss for the year.
The best way to claim the loss is to sell the shares by yearend. If a buyer cannot be found at a later date (note: both shares are still trading — Fannie of Washington on the New York Stock Exchange, and Lehman Brothers Holdings Inc. of New York over the counter), the clients could sell to friends or family (other than a spouse, siblings, ancestors or lineal descendants) for a nominal sum (say, a dollar for the whole lot). In some cases, the broker may even purchase the shares for a nominal sum if no buyers can be found.
Taxpayers should also keep in mind the wash sale rules when selling stock to realize a loss. In a nutshell, the wash sale rules preclude the recognition of loss if the taxpayer purchased substantially similar securities 30 days before or 30 days after the sale.
Worthlessness for tax purposes
If the shares are not sold, the taxpayer may still be able to take a loss, if he or she can prove worthlessness. If the conditions for claiming worthlessness for tax purposes are met, the taxpayer can take a capital loss. The securities are deemed sold on the last day of the tax year for zero proceeds. The taxpayer’s capital losses in any given year offset their capital gains for that year. Up to $3,000 of any remaining loss can be used to offset other ordinary income. Any excess is carried forward to future years until fully utilized.
But the tax rules for worthlessness differ from the general perception of worthlessness.
For example, a client may think a bankruptcy filing by a company makes the stock worthless. For tax purposes, current insolvency or the bankruptcy filing — especially if it is Chapter 11 (a reorganization) — is usually, in and of itself, not sufficient to indicate that the company is completely worthless. And being nearly worthless is not sufficient to make it worthless for tax purposes.
For tax purposes, worthlessness has to be evidenced by current balance sheet insolvency and a complete lack of future value.
Future value
The complete lack of future value is usually proved by the occurrence of one of more events, including cessation of business, adoption and commencement of a plan of liquidation, sale of assets and distribution in liquidation to creditors, and bankruptcy/receivership. In some cases, the extreme nature of the insolvency may be sufficient to also prove a complete lack of future value.
Timing is important too. The worthlessness deduction can be claimed only for the year the stock became worthless, not the year before or the year after. Proving the completer lack of future value and the exact point in time at which it occurs has been the cause of litigation between the Internal Revenue Service and taxpayers in numerous cases. The IRS regulations do not provide clear-cut rules for determining worthlessness.
In all likelihood, Fannie Mae is not likely to be deemed worthless for tax purposes by yearend. Lehman Brothers, which is based in New York, may make the cut, but it will be hard to make the case if the shares still are trading OTC.
Remember, it has to be completely worthless before you can take a tax loss, unless you sell it.
Tax INsight is prepared by experts who are active members of the American Institute of Certified Public Accountants. Tax INsight appears on the web and in IN Daily every Tuesday. Comments are welcome at
IN_Editor@InvestmentNews.com.
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