You thought those 5,000 shares of Stained Glass Windshield Co. (Ticker: STAIN) were a bargain at $0.25 per share. But now, six months later, the stock seems to have disappeared from all listings. When you asked a Foolish friend about it, she said the shares were worthless. Are you looking at a capital loss here? Probably -- but let's make certain.

If the company was literally liquidated, you'll be notified of that (with any luck) and will likely receive a 1099-DIV form at the end of the year that shows a liquidating distribution to you, the shareholder. You can treat the amount and date of this distribution as your sale price and sale date. With this information, using your original cost basis in the shares, you can compute your gain or loss. (Note that getting a 1099-DIV under these circumstances is the exception, not the rule.)

If the company has not actually been liquidated, but is simply deemed worthless, the rules are a little bit different. You can deduct a loss for worthless stock or other securities (e.g., a bond, debenture, note, certificate, or other evidence of indebtedness). If you determine that the shares are worthless, you are deemed to have disposed of the shares on the last day of the taxable year in which they become worthless. So your loss could be either a short-term or long-term loss, depending on what date you purchased the shares.

For example: You originally purchased your 5,000 shares of STAIN on Dec. 12, 2004. You determine that STAIN is worthless in July of 2005. According to the rules outlined above, you technically disposed of your STAIN shares on Dec. 31, 2005; since that's more than a year after their purchase, it counts as a long-term capital loss. On your 2005 tax return, you would report the "sale" date as 12-31-05, indicating a "sale" price of zero.

Keep in mind that you can only claim a loss deduction if a stock or security is totally worthless -- not partially worthless, nor simply down a bit in value. To stay on the right side of the law, make sure that the stock is worthless in the eyes of the IRS. Many stocks that have taken major hits in the market may still be alive, even though they are trading for mere pennies per share.

Your broker should be able to tell you if the security is still trading. Some brokers even have divisions that will buy back your remaining shares (for pennies), allowing you to close out your position. But make sure the broker buys the shares from you. Simply giving the shares to your broker to clean up your account will not automatically give you a worthless stock deduction.

Suppose you finally track down your STAIN shares and find them alive and kicking -- kinda. The shares aren't traded on any exchange, but the company is still operating under bankruptcy protection, with a highly uncertain future. At this point, it's very likely that your stock is still not "worthless" as defined by the tax code. The company is still somewhat viable according to published reports and financial analysis. Its bankruptcy, and your inability to sell your shares, still doesn't make those shares worthless for tax purposes -- which means no deduction for you.

The IRS definition of "worthless" is a loose one, highly subject to interpretation, which is why a number of these cases have gone to court. Reviewing all the relevant cases helps narrow down a few key factors for identifying "worthless" stock:

  • What is the current liquidating value of the stock? What value might it achieve in the future through the foreseeable operations of the corporation? If the answer to both questions is "zero," you can almost certainly claim a loss.

  • If the corporation's liabilities exceed its assets, and there is no reasonable hope or expectation of profit should the business continue, the stock is worthless.

  • If you can show balance sheet insolvency and identifiable events, such as a cessation of business or a sale of substantially all of the company's assets, the stock is very likely worthless.

So the determination of "worthless" will require some financial statement analysis, and it could still be subject to interpretation (and disagreement by the IRS). It's not as easy as you might think on first blush.

Why go through the hassle? Here's a way to get rid of your shares with minimum hassle and maximum tax benefits.

Sell the stock to your mother-in-law
Consider selling the junk for pennies to a friend or distant relative. (In-laws qualify, as does anyone other than your spouse, siblings -- either whole or half-blood -- ancestors, or lineal descendants.)

You then have a closed transaction, and the loss is certain and deductible in the year of sale. If the stock ever comes back and is worth something, at least the money stays with friends or family. Here's how you might 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 your 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.

Bingo! For a pittance, your friend or relative has just bought a placemat or birdcage liner ... but you have a capital loss. You have a stock sale, a closed transaction, and an indisputable loss. No financial statement review and analysis. No subjective decisions regarding any potential future turnaround by the company. No second-guessing from the IRS. Sweet.

IRS Publication 550 has more information on worthless securities, but it still doesn't address the complex question of exactly when a stock becomes worthless in the eyes of the IRS. Don't risk running afoul of Uncle Sam; if you're holding some questionable stock, consider selling the junk and being done with it.

When he's not dealing with tax issues, Roy Lewis is a motivational speaker who lives in a trailer down by the river. He understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.