Although it may not seem so in volatile markets, investing in stocks is a sound, long-term way to build wealth. It also offers some tax advantages.

In the best scenario, your holdings appreciate and you sell them for a nice, and lower-taxed, capital gain. Even when a few assets don’t do as well, you always have the silver lining of being able to use those losses to offset your taxable gains.

But what if your shares of a corporation dropped off the stock market radar before you were able to unload them? You might be able to write off the holding on your tax return as a worthless stock.

Worthless means zero value

Before you can use this tax break, the stock must be totally worthless.

Just because a company is in bankruptcy, or its stock isn’t trading, doesn’t necessarily mean it’s worthless. If it’s worth even a few pennies, it still has value in the eyes of the IRS.

If you truly do have a dead stock in your portfolio, you treat it on your tax return as if it were a capital asset you sold for zero dollars on the last day of the tax year.

Documentation for the IRS

When you report a worthless-stock transaction, you don’t have to put the details of the stock’s demise on your return.

However, tax experts say if you’re questioned by the IRS, you need to be prepared to show:

  • There is no hope investors will ever get anything for their holdings. This isn’t always easy, so do your homework.
  • When the security became worthless. You must reasonably determine the date the stock lost all its value.

Once you’re armed with that information, it’s time to report your loss.

Filling out the form

Report the valueless stock in either Part I or Part II of Form 8949, depending on whether it was a short-term or long-term holding. If an asset became worthless during the tax year, it is treated as though it were sold on the last day of the year. That could affect whether your capital loss is a short- or long-term one.

Your worthless stock losses, either short-term or long-term, can offset capital gains dollar for dollar. If you have more in capital losses than gains, then your loss can offset ordinary income up to $3,000. Additional losses can be carried forward to future tax years.

If you discover you didn’t claim a valueless stock loss on your original tax return in the year it became worthless, you can file a claim for a credit or refund due to the loss. Just file Form 1040X to amend your return for that year.

You have up to seven years from the date your original return had to be filed or two years from the date you paid the tax, whichever is later.

For additional information, check out Chapter 4 of IRS Publication 550, Investment Income and Expenses.