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.