Investors in both stocks and bonds have been groaning about the worthlessness of some investments for almost two years now. But the Internal Revenue Service has a strict definition of "worthless" that you'll need to meet before claiming a deduction for your worthless securities.

Surely it's small consolation to investors in WorldCom or Enron. According to the tax code, investors are able to claim a loss for the cost basis (what you paid for the stocks or bonds) in the year that the securities become worthless. The loss is claimed on Schedule D of your 1040.

As with a loss on any security, you can't claim your "paper gain," you can only deduct as a loss the money you actually plunked down to purchase the stocks or bonds. (A quick aside: The tax code doesn't allow you to deduct losses incurred in a tax-deferred account such as an IRA or a 401(k) plan.)

To claim a deduction for worthless stock or bonds, though, you must be able to prove that the securities became completely worthless. Now, euphemistically, WorldCom and Enron shares certainly seem like they're worthless -- now trading around 15 cents per share -- but the IRS would disagree. After all, 100 shares will still get you ... well, a movie and some popcorn.

In other words, a company's bankruptcy, criminal indictments of the executives, or the delisting of its stock won't make your investments worthless in the eyes of the IRS.

To prove total worthlessness, investors need to prove that the securities truly have zero value. For instance, a company declared bankruptcy, stopped doing business and is insolvent. If the company's shares are still trading -- even at pennies per share -- they're not considered worthless, and no deduction will be granted. Nor can you claim a deduction for a partially worthless corporate bond.

So What to Do?

Sell those shares or bonds while you still can. There's no additional tax benefit to waiting until the securities are worthless, and you'll be assured of a deduction in 2002. If you're a big believer in a company's turnaround story, you can always repurchase shares at a later date. Just make sure you don't buy back the same securities within 30 days of selling them, or you'll run afoul of the wash-sale rule, which would essentially disallow the deduction.

Selling shares that are traded on the so-called pink sheets can be tricky business for individual investors -- you'll likely have to turn to a full-service brokerage to execute that trade. If that seems too costly or unwieldy, you might be tempted to hang on to those shares until they do become worthless.

If that's the case, look for news that can bolster your claim of worthlessness. Worthless securities only can be deducted in the year they become completely worthless. You must be able to prove that they had some worth the previous year, and point to specific events that caused the worthlessness in the year for which you're claiming a deduction.

Because determining worthlessness can be such a tricky business, the IRS allows you to file an amended return up to seven years from the initial due date to claim a refund for worthless securities. For example, if you hold securities that you learn became worthless in 2001, you have until April 15, 2009, to file an amended return (1040-X) for the 2001 tax year, claiming the deduction.

If by the end of this year you still can't ascertain whether or not a company's condition is hopeless, the Tax Court advises that you claim a deduction anyway. In other words, you're best off claiming a loss for the earliest year when it may possibly be allowed, and to renew the claim in subsequent years. Of course, that entails filing amended returns for the year(s) in which you claimed a deduction that wasn't valid.

"The taxpayer is at times in a very difficult position in determining in what year to claim a loss," a court acknowledged, according to J.K. Lasser's Your Income Tax Guide. "The only safe practice, we think, is to claim a loss for the earliest year when it may possibly be allowed and to renew the claim in subsequent years if there is a reasonable chance of its being applicable for those years."

Even so, the best course of action is to sell the stocks or bonds as soon as possible, and buy some investing basics books with the proceeds.

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