How to Deduct Bankruptcy Loss on Taxes

How to Deduct Bankruptcy Loss on Taxes
••• miflippo/iStock/Getty Images

As any business owner or investor knows, positive returns from extending business credit or purchasing stock are never absolutely guaranteed. If a company you invested in, or extended credit to declares bankruptcy, it's possible to offset at least part of your loss when filling out your federal income tax return. First, however, you need to clarify the nature of the loss.

Completely Worthless Stock

Stock does not typically become worthless until a company emerges from bankruptcy, issues new stock and cancels the old stock. Just because a company files for bankruptcy doesn't necessarily mean the stock you purchased is worthless. According to the Internal Revenue Service, it still has value even if it's worth only pennies. If you can sell the stock, or if it has become truly worthless, your losses can offset either short-term or long-term capital gains on a dollar-for-dollar basis using IRS Schedule D and Form 8949. If your capital losses exceed your gains, you can use up to $3,000 of loss to offset your other income. Additional losses beyond that limit can be carried forward to future tax years.

Unpaid Business Debts

Small businesses can fall victim to bankruptcy-related bad debt, if a customer files bankruptcy and does not pay what it owes based on credit extended. You must have used accrual-basis accounting, in which you extended your customer credit, and then recorded an accounts receivable for that amount. In the year that the business debt is considered worthless, deduct the amount on Schedule C, line 6 as business bad debt.