Make the Most of Worthless Stock

At some point, you've probably bought into a promising stock, only to watch it go belly-up. But if you give up and do nothing after your ill-fated holding bites the dust, you could be making a big mistake.

Those worthless shares aren't as worthless as you think. They represent a capital loss, which you can use to offset some of your capital gains on your tax return. If you sold one stock for a $4,000 loss, but reaped a $6,000 gain when selling another, you'll only have to pay taxes on $2,000 of that windfall.

If your worthless company was actually liquidated, you'll face a simple process. Typically, you'll receive a 1099-DIV form at year-end showing a liquidating distribution. Treat this as if you sold the stock for the amount of the distribution. The date of "sale" is the date that the distribution took place. Using your original cost basis in the shares, you can now compute your loss.

Your Uncle Fred could use some new kindling
If the company hasn't actually been liquidated, though, things get a little more complicated. You'll need to make sure your shares are totally worthless before claiming a loss. If so, you can sell the shares through your brokerage -- but sometimes that can be difficult or  expensive. After all, would you want to pay a commission to sell stocks worth $0?

Alternatively, your brokerage might buy the shares from you for a penny. If not, you can sell them to a friend (or cousin, aunt or uncle) for pennies. (Warning: Per tax rules, selling them to a spouse, siblings, parents, grandparents, or lineal descendants won't work.) Here's one way to do it:

1. Get the actual stock certificates from your broker.
2. Formally sell the shares to the purchaser, with a check for payment and a bill of sale.
3. Sign over the stock certificate (on its back) to the purchaser. Have the signatures verified by your banker and/or a local stockbroker.
4. Send the certificate to the stock transfer agent. Explain that the shares have been sold, and ask them to cancel the old shares and issue a new certificate to the new owner.

By selling the shares, you have a closed transaction with the stock, and you can declare a tax loss. Your friend, relative, or broker -- for a pittance -- has just bought a placemat or a birdcage liner.

Last but not least, you can frame a certificate for worthless shares and hang it in your office, as a reminder to pay more attention to your holdings.

Be proactive
The best way to deal with worthless shares is never to have them in the first place. Keep an eye on swooning shares in your portfolio, and sell any you no longer believe in. Even if they never go out of business, some companies may still cause you grief -- perhaps just by being good, but overvalued, stocks.

Motley Fool CAPS can help you spot a stock's early warning signs. I've rounded up a handful of stocks that have earned our community's poorest one-star rating, a sign of CAPS members' belief that these stocks won't do well relative to the market:

Data: Motley Fool CAPS.

Do you have a worthless stock story to share? A dumbest investment you'd like to tell us about? Talk to us! Leave a comment below, and tell your fellow investors what mistakes to avoid.