Writing Off That Enron Stock

A poor investment choice could still make for a rich tax break. Here's how.

BACK IN THE good ol' days — when people were actually making money in the stock market — did you buy Enron (ENRNQ)? And then, for the sake of diversification, add a little Kmart (KM) and a dash of Global Crossing (GBLXQ) to the mix? If so, I can empathize. Oh, it all seemed like a good idea at the time....

For the many of us who made disastrous investment moves like these, the saving grace is we can at least get a tax deduction. The deduction is limited to the amount of your capital gains for the year (if any) plus $3,000 ($1,500 if you're married but file separately). Any excess loss then carries over to next year, subject to the same $3,000 (or $1,500) limitation. Hey, it's better than nothing!

You've got two ways to reap these tax rewards. You can either sell your shares for whatever pathetic price they can fetch and take a standard capital loss. Or, if the stock is truly worthless — meaning it has no value whatsoever — you can claim it as worthless stock on your tax returns. Given the choices, many wait for the latter, even though the tax breaks are essentially the same. Why? Because we all hate to admit that we've made a mistake. So even if a stock has plummeted from, say, $90.56 a share to 16 cents (Enron's all-time high and current price, respectively), we hang on, hoping that it will return to its former glory. It's not a wise move. For starters, let's face it, once a stock has fallen that significantly on horrible news, it's not likely to recover — at least not anytime soon. And it can also make taking your capital-loss deduction just that much harder, since the worthless-stock deduction rule is tricky business.

To claim a stock as worthless, you must first correctly identify the year the shares become wholly without value. That's because you get to claim your write-off in that year and that year only. This sounds pretty simple, but it isn't. Unfortunately, the IRS doesn't consider your battered and bruised shares worthless until it's clear they have no liquidation value and there's zero hope they'll regain any value in the future. Over the years, there have been many attempts to interpret this seemingly uncomplicated principle. For example, the IRS said in a 1977 ruling that a bankruptcy filing doesn't necessarily establish complete worthlessness, because shareholders aren't always totally wiped out. Several court decisions have taken slightly more liberal views of this issue, but they don't establish any firm guidelines.

For a real-life illustration of why this remains a confusing area of the tax law, I give you Winstar Communications (WCIIQ). This poster child for the devastated telecom industry declared bankruptcy in April 2001. Then in December, another corporation purchased all of Winstar's assets. Guess how much the poor shareholders came away with? Absolutely nothing. And yet, as I wrote this article, you could (amazingly) still buy and sell Winstar shares on the OTC Pink Sheets for 0.4 cents each. Given that 10,000 shares equate to a whopping $40, would the IRS concede the stock is completely worthless? At this price, the brokerage fees would almost certainly exceed the sales proceeds. And that's assuming you could find a broker willing to sell such garbage. If this isn't an example of a wholly worthless investment, I don't know what is. But I'm not sure the IRS would agree. And therein lies the problem.

So here's my advice: If you own shares of a company that's clearly on life support, pull the plug. Sell your soon-to-be-worthless shares while there's still a market (however misguided) for them. This strategy has two big advantages. First, you'll net at least a little bit of cash, whereas if you procrastinate, you'll probably get nothing. Second, making the sale will unequivocally trigger a tax loss. Consider the resulting tax-savings balm for your pain. And consider the alternative: If you stubbornly hang on, you risk entering the same gray area occupied by Winstar shareholders, namely that the stock certainly is near worthless, but maybe isn't truly worthless. It could be a long wait until your stock becomes completely worthless in the eye of the IRS, which means an equally long wait for any tax write-off.

Now I don't get paid to be a stock analyst, but the following candidates quickly come to mind for immediate tax-saving sales: Adelphia (ADELA), trading at 81 cents; Enron, trading in bankruptcy at 16 cents; Global Crossing, trading in bankruptcy at seven cents; Kmart, trading in bankruptcy at $1.03; and Williams Communications Group (WCGRQ), trading in bankruptcy at three cents. If you still hold these dogs, you just might want to give them the boot while the booting is good.

What if you still own shares that have passed into Winstar-style tax never-never land? Well, if your broker refuses or is simply unable to sell the shares, get that in writing, and consider the stock worthless. But if you can still sell the stock, the brokerage fee might exceed the sales proceeds. So here's one way to trigger your tax loss without paying for the privilege. Assuming you can get your hands on the actual share certificates, sell them to your cousin, brother-in-law, sister-in-law or next-door neighbor for whatever pitiful sum they are allegedly worth. Voila! The sale liberates your tax loss. That said, please don't sell the stock to your spouse, parent, grandparent or other ancestor, or to your brother, sister, child, grandchild or other lineal descendant. All these individuals are considered "related parties," which means your tax loss will be disallowed and then your poorly chosen investment will become even more worthless.