Monday, September 29, 2008

Is my stock worthless? Part I

Stock which is worthless results in a capital loss. However, the devil lies in the details, and in this instance, the details are important

Say a long-time client comes to your office, with a stack of yellowed papers and tells you that he ‘found these while cleaning out some boxes in the attic over the summer,’ and his ‘co-worker/neighbor/friend told him that he could write these off as a loss’. He also tells you that the papers are the ‘buys’, that he has never received dividends on these stocks, and that he has no other records. Does the client have a deductible capital loss?

It’s up to the tax preparer at this point to do some hard research. Find out if the stock was ever acquired by another company (depending on the industry, this very well may be what happened). Usually, the acquiring company will have traded their stock for stock in the old company (such as Chase trading its stock for that of Bear Stearns and WaMu), and such a trade can still be affected via a broker or the acquiring company. If for some reason, the opportunity to trade in the stock has passed, then your client does not have worthless stock, but potentially a capital gain or loss based on the value of the stock on the date of the trade. A well-organized client can assist greatly in this research (they may remember getting some kind of letter, but not understanding the contents, merely filed it without action), but more likely than not the client’s records (and memory) will be spotty at best.

If the stock has not been acquired, and research turns up no quotes on the major markets, then you likely have a worthless stock – provided three hurdles can be met. The first hurdle is determining whether the stock is truly worthless. It’s not enough that the stock was delisted from the NYSE or NASDAQ, since both exchanges have minimum capitalization amounts and other rules (such as annual listing fees) which impact whether or not a stock remains listed, and since other viable trading alternatives remain. For example, if a stock has been delisted, investors can still trade the stocks over the counter, in the so-called ‘pink sheet’ market. One might also be able to sell the stock to a broker or other party who specializes in such trades. If any or all of these options exist, a market for the stock exists, and therefore it is not worthless. Although delisting can be an indicator of poor financial health, in order to be truly worthless, no market must exist for the stock, and there must be no likelihood that investors will ever recover their investment (or such recovery must be highly unlikely). A prime example of such an instance is Enron, whose stock was cancelled and whose website states: “it is not believed that the value of Enron Corp.’s assets will exceed the amount of its allowed claims. Therefore, we do not expect the Enron Bankruptcy Estate to ever make distributions to the former holders of Enron Corp. stock.”[fn.1]

If no one – not even your aunt Mabel – is willing to take a risk on your stock, then you’ve cleared the first hurdle to meeting the ‘worthless’ definition. You still need to clear two more hurdles.

The second hurdle is the ‘no likelihood of recovery’ hurdle. Generally speaking, if the company has filed for bankruptcy protection, this hurdle is easy to clear – secured investors will get something, common stockholders won’t. If the company ceased operations without a bankruptcy filing, then further investigation is warranted (if possible) into whether the company was in receivership or some other avenue was made to repay investors some or all of their investment. If so, the client’s recourse is to claim that repayment, and possibly deduct any shortage which results in a capital loss.

Unfortunately, one hurdle still remains, and it’s the one most likely to disappoint your client. Section 165(g)(1) requires the recognition of the capital loss as of the end of the year in which the security became worthless (exactly when during the year that the security became worthless is irrelevant; on a tax return, it is reported as of the last day of the tax year) . And that’s usually the rocks upon which the client’s ship runs aground. Unless you can point to a date within the previous year (or a date during a prior year which can still be amended)[fn. 2], you’re likely to have an unrecognizable loss. Generally speaking, you’ll be able to determine that no market exists because you’ll look at an online listing in Yahoo! or similar source and see no current trading on any market, but that source will only tell you when trading on the shares ceased (and in some instances, will only give a date, not a year!). It won’t tell you whether investors have any hope of recovery of funds (hurdle two) or when that determination was made (hurdle three). Unless you can reasonably determine when those two events occurred, the client cannot recognize the capital loss.

Thus the lesson to be learned: Clients who do not keep good records, or closely track the myriad of small holdings that they may have, run the risk of missing out on an important deduction, or finding themselves subject to an unpleasant surprise down the road. It’s important for tax preparers to ask a new client – and even existing clients – when they purchased their home, as well as reviewing a client’s financial holdings on a regular basis. If a client owns a dividend-paying stock which stops paying dividends, don’t let the stock slip through the cracks – it may be in a downward spiral, and should be monitored. (The same goes for stocks which are still paying dividends, but the dividend is less than $1.00.) It’s also a good idea to avoid the temptation to go ‘completely electronic’ and maintain at least some client records in an accessible ‘permanent file’ in the event the client forgets, or loses, their copies. Although this won’t catch every problem, it may trigger the client’s memory before it’s too late.


[1] See: Last accessed September 29, 2008.

[2] In this instance, the period to amend the return is extended to seven years, instead of the general three year limit. See Publication 550.

When a home sale could result in capital gain

Given the current economic situation, a taxpayer selling their home may not be a frequent occurrence, but tax preparers should still be vigilant. It’s all too easy to look a the current mortgage rules – exempting the first $250,000.00 to $500,000.00 of capital gain – and forget that these rules have only been in force since May, 2007. Prior to May 2007, the old rules – allowing a deferral of gain, provided reinvestment of the funds within two years – were in effect.
Let’s see how forgetting that fact can have an impact:
X, a single homeowner, buys her home in May, 1986 for $100,000.00. In October, 1996 X sells her home for $200,000.00, and files form 2119 to defer the $100,000.00 capital gain. At the same time, X buys her new home, for $225,000.00.
In 2008, X sells her home for $460,000.00, and heads down to Harry’s Tax Service to have her taxes prepared. Harry dutifully notes that the cost basis of the home was $225,000.00, the sales price is $460,000.00 and the capital gain is $460,000 less $225,000.00, or $235,000.00. Since the $235,000.00 capital gain is less than the $250,000.00 exemption, Harry claims no capital gains tax.
Sadly, Harry’s wrong, because X’s house was purchased under the old rules, and under the old rules, the basis of the new home must be reduced by any capital gain deferred. Thus, X’s basis in her home isn’t $225,000.00, but $225,000.00 less the deferred gain of $100,000.00, or $125,000.00.
Revisiting the earlier transaction, X’s capital gain is now $335,000.00, or $85,000.00 over the $250,000.00 exemption amount. X might not be happy to hear that she owes capital gain tax, but it’s better you tell her while preparing her return, then having her show up in your office with a CP2000 letter telling her she has a balance due of not only the capital gain tax amount, but the refund that she received!