Many of us have bought stock in a company that later failed over the years. While you may prefer to forget such an investment, don’t forget to claim your rightful capital loss deduction on your tax return. But beware that figuring out when to claim a worthless stock loss can be tricky.

Here are the two ways you can salvage some tax savings from unfortunate stock market forays:

1. Trigger a capital loss deduction by selling the worthless shares. However, your write-off is limited to the amount of any capital gains for the year, plus $3,000 (or $1,500 if you use married filing separate status). After this, any leftover capital loss gets carried over to next year and is subject to the same $3,000 (or $1,500) limitation.
2. Wait until after your shares have become wholly worthless to claim a capital loss deduction, because under the tax code, you get no deduction for partial worthlessness. Once again, your write-off is limited to the amount of any capital gains for the year, plus $3,000 (or $1,500 if you use married filing separate status).

Beware: Bankruptcy May Not Trigger Worthlessness

Unfortunately, relying on the worthlessness rule can be tricky. You must correctly identify the year when the shares become totally worthless and then claim your write-off in that year and that year only. This sounds pretty simple, but sometimes it isn’t. Why? Because the IRS doesn’t consider your battered and bruised shares to be wholly worthless until it’s clear they have no liquidation value and there’s no hope they will regain any value in the future.

The situation remains confusing, even though there have been many attempts to interpret this principle over the years. For example, the IRS has stated that bankruptcy proceedings don’t necessarily establish complete worthlessness for a company’s stock. (IRS Revenue Ruling 77-17) This is due to that fact that shareholders are not always totally wiped out, and there is some hope that the shares could become valuable again. Several court decisions have taken more taxpayer-friendly views of this issue, but they don’t establish any firm guidelines.

This confusion is only made worse by the fact that shares of delisted bankrupt companies may continue to trade on the over-the-counter market (via a system called the “Pink Sheets”) even after it is clear that shareholders will get nothing in the bankruptcy proceedings and the shares have been legally canceled. While this seems to make no sense, it happens.

Canceled shares of a delisted bankrupt company may be trading for a few cents each (or a fraction of a cent) on the Pink Sheets market and still not qualify as worthless by some IRS auditors. Sticklers might disallow losses until all trading in the shares has ceased. Who knows how long that might take?

Of course, the simplest solution is to sell any shares you believe will soon be worthless while they are still listed on the NYSE, NASDAQ or American Stock Exchange. Taking this step has two big advantages:

1. You will net at least some cash, but if you procrastinate, you may end up with nothing.
2. Selling the shares unequivocally triggers a tax loss. In contrast, if you hang on, you risk entering the Pink Sheet system for delisted stocks, where it’s unclear if you can claim any loss until you actually sell. And if you don’t end up selling, it could be a long wait before the stock becomes completely worthless in the eyes of the IRS and you qualify for a tax write-off.

What About Losses on Stock Held in a Traditional IRA?

Suppose you are unfortunate enough to own worthless, or nearly worthless, stock in a traditional IRA. Can you write it off? Sadly, the answer is probably not.

The reasoning is that, in general, money invested in an IRA is pre-tax. So if you’re allowed to write-off a subsequent loss, that would be double-dipping, or taking two tax breaks on the same dollars.

On the other hand, if some contributions made to the IRA were non-deductible, you might get a write-off. According to the IRS, your basis in an IRA is equal to non-deductible contributions. Earnings on the account, plus tax-deductible contributions, aren’t part of your basis. In order to claim a loss, you have to show that part of your basis was lost. In other words, a loss would have to be large enough to wipe out your tax deductible contributions and your earnings, which is an unlikely scenario.

If You Hang on, You Have Extra Time to Figure Out When to Claim a Loss

Should you decide to hold onto distressed shares until it becomes amply clear that they are indeed totally worthless, the Tax Code says you must claim your capital loss in the year when such total worthlessness occurs. For the reasons explained earlier, however, it’s not always clear exactly which year that is.

A little-known exception in the tax law grants taxpayers a seven-year statute of limitations period to claim a worthless stock loss, instead of the typical three years. Why? Because Congress recognizes that determining the proper year to claim a worthless stock loss can be problematic. So the special seven-year statute of limitations period gives you an extra four years to figure it out.

It is clear that there are potential problems with claiming worthless stock losses. It seems the best course of action is to sell distressed shares before they are delisted, and trigger your capital loss and move on while avoiding all the issues and hassles explained. If you procrastinate and the stock becomes delisted, follow the tax filing advice above. Contact your tax adviser if you have questions or want more information.