Stock Losses and Taxes

Are there tax advantages to be gained when stock that you own decreases in value?  The answer is yes, at least to some extent.

Here are some planning considerations:

  • Losses can only be deducted when you sell the stock at a loss.  The reduction in value on stock that you continue to hold is not deductible.  So if your stocks go in the tank but you do not sell them, you don’t get a deduction.

  • If you sold stock at a gain earlier in the year, you can sell other stock at a loss later in the year to eat up the gain.  On your tax return, stock sold at a gain is netted against stock sold for a loss, to arrive at your net gain or loss for the year.

  • The tax code is not overly generous when it comes to deducting losses on investments.  The loss deduction is limited to $3,000 of the net loss per year.  Losses in excess of $3,000 can be carried forward to future years.

  • Beware of “wash sales.”  A wash sale occurs when you sell stock at a loss and then buy the same stock within 30 days before or after the sale.  (Example:  you sell Stock A at a loss on August 1 and then re-purchase Stock A on August 15.  This is a wash sale and the August 1 loss is not currently deductible but instead adjusts the basis of the stock you purchased on August 15.)

  • It is important to know your basis in the stock.  For stock you purchased, your basis is your purchase price.  The basis of inherited stock is generally the stock’s fair-market value on the date of death of the person you inherited the stock from.  If you receive stock as a gift, you generally take on the basis of the person who gave you the stock.

Here is an example of the above concepts:

You bought stock several years ago for $750.  Earlier this year, the value of the stock rose to $1,000.  Then the market crashed and the stock dropped to $500, at which time you sold it.  Your deductible loss is $250 ($500 sale price minus $750 basis).

In the above example, note that the fact that the stock rose in value to $1,000 at one time is irrelevant for tax purposes.  The only thing that matters for tax purposes is your basis and the sale price.


Is There a Way to Protect Yourself from Tax Return Identity Theft?

People who have read my multi-part series on Wendy Boka, the widow who went through an identity theft nightmare with the IRS, often ask if there’s anything they can do to protect themselves from something similar happening to them.

In the case of what happened with Wendy, the answer is, unfortunately, that there’s very little you can do.

Identity theft on tax returns (meaning, someone filing a fraudulent tax return using your name and Social Security Number) falls under two broad categories:

  1. People who got your information through “traditional” ID theft. “Traditional” is the term I am using here to describe a situation where someone stole your purse or your wallet, or got ahold of sensitive documents.
  2. Your spouse or loved one dies and a thief gets ahold of their name and Social Security Number through the Death Master File, which is published by our wonderful, helpful government and is a treasure trove for thieves. This is what happened to Wendy — her husband Brian died and someone got ahold of his name and Social Security Number, almost certainly from the Death Master File.

With category 1, your best defense is the common-sense tips about safeguarding your information. The IRS offers a variety of tips on this webpage.

Category 2 is much harder to defend against. One tax pro I was talking to about Wendy’s situation speculated that the only way to protect yourself would be to file a tax return as soon as possible in January, even if you had to report all zeros because your documents weren’t available yet, and then amend later to report the correct information.

For example, let’s say Annie and Al are married. Al dies during 2013. In order to protect against anyone who might have stolen Al’s identity from the Death Master File, Annie files a tax return as soon as the IRS will start accepting 2013 tax returns, even though she doesn’t have all of her documents yet. She’ll file an amended tax return as soon as she gets all of the documents.

This could, theoretically, block an identity thief from filing a return in Al’s name.

I am using this example hypothetically. DO NOT TRY THIS AT HOME!!!!!!!!!!!!!!!!!!!!

This example was pure speculation in a conversation I had with another tax pro. I have no idea if this would work, or if it would even be legal, since you’re supposed to file a complete and accurate tax return and you would be knowingly NOT filing a complete tax return.

I suppose if you attached a Form 8275 to tell the IRS what you were doing, maybe it would be okay. I don’t know.

And isn’t it sad that our government’s publication of deceased people’s names and SSNs causes us to speculate about doing such things in the first place?

I’m open to suggestions from readers: what options do you think people have for protecting against a deceased person having their identity stolen?

Insolvency and Canceled Debt: Make Sure You Can Prove It!

If you have a debt that gets canceled, the general rule is that you must report the canceled debt as income. For example, if the credit card company forgives $5,000 of credit card debt, you’ll need to report $5,000 of income on your tax return.

Many exceptions apply, such as debt cancellation relating to your primary residence (as in a foreclosure), bankruptcy or insolvency.

This blog post will focus on the insolvency exception.

What is Insolvency?

Insolvency is when the amount of your debt is greater than the amount of your assets, with assets being things such as cash in the bank, or the value of property you own.

Example: you owe $15,000 on a credit card and $100,000 on a mortgage, for a total of $115,000 of debt. Your home is worth $105,000, your car is worth $5,000 and you have $1,000 of cash in the bank, for a total of $111,000 of assets. You are insolvent by $4,000.

Insolvency and Canceled Debt

Canceled debt is not taxable to the extent you are insolvent. Using our example above, let’s say the credit card company cancels all $15,000 of credit card debt. You would report $11,000 of taxable income from this cancellation — $15,000 of canceled debt minus $4,000 insolvency.

Reporting Insolvency

Lenders will typically issue a Form 1099-C to you when they cancel a debt. In order to show that some or all of the canceled debt is not taxable due to insolvency, you’ll need to complete a Form 982 and mark the box that says “Discharge of indebtedness to the extent insolvent.”

And that’s it. Per the instructions to Form 982, no further explanation or attachments are needed.

In practice, though, the IRS often questions claims of insolvency by sending a notice to you several months after you’ve filed your tax return.

Insolvency Worksheet

When I’m helping someone with canceled debt, I have the person fill out the “insolvency worksheet,” which you can find on page 8 of IRS Publication 4681.

In my experience, submitting the insolvency worksheet to the IRS when they ask for proof of insolvency has been sufficient. I’ve never had them come back and ask for additional documentation beyond the worksheet, though they certainly could ask for additional documentation.

In order to further protect yourself, I would recommend keeping copies of bank statements and anything else that can prove the numbers shown on the worksheet.

Caveat: Beware of 401(k)s and IRAs

Money held in retirement accounts counts as an asset. You must include this money on the insolvency worksheet.

I have seen this derail attempts at claiming insolvency before. Clients have been sure, initially off the top of their head, that they were insolvent by thousands of dollars … except they hadn’t accounted for the thousands of dollars held in their 401(k). When they filled out the insolvency worksheet, they realized that they weren’t nearly as insolvent as they thought they were!

Incorporate Your Life? Not So Fast

At a presentation I gave to prospective entrepreneurs earlier this year, one of the participants asked if I had read a book called “Incorporate Your Life.” I said I had not. The participant went on to say that it was a really interesting book on how you could turn personal expenses into tax-deductible expenses.

I tried explaining how non-business expenses can’t ever really be turned into tax-deductible expenses, but I’m not sure the message sank in.

After doing some research, I believe the participant was referring to a book called “Incorporate & Get Rich: How to Cut Taxes 70% & Protect Your Assets Forever!”.

I’ve never read the book so I won’t comment on the contents of the book. Though I think the over-the-top title speaks for itself….

But I will say this: simply having a business entity DOES NOT make everything in your life tax deductible.

Forming a corporation doesn’t magically make your mortgage deductible. Forming a corporation doesn’t make your grocery bill deductible. Forming a corporation doesn’t make the purchase of a big-screen TV for your living room tax deductible.

Legitimate business expenses are tax deductible.

Personal expenses are not tax deductible.

Should you take advantage of every deduction available? Of course! But don’t start a business just to get tax deductions … because that’s not how it works!

There are no magic bullets or tax fairies*.

(*-To give credit where credit is due, my tax blog-o-sphere buddy Joe Kristan is the one who coined the “tax fairy” phrase. I’m green with envy over the fact that I didn’t think of it first!)

Life After DOMA: Audits of Prior-Year Returns

We know that couples in same-sex marriages must file their 2013 federal taxes as a married but they are not required to amend prior-year tax returns where the couple filed as two single people.

How will this concept work with audits of returns within the current statute of limitations (2010-2012)?

The answer is surprisingly straightforward:

  • If the person’s original tax return was filed as a single person, they would be audited as a single person. This assumes that the original return was filed before September 16, 2013. See this blog post for more details.

  • If the person originally filed as single but they then submitted an amended tax return as married after the DOMA ruling, they and their spouse will be audited as a married couple.