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IRS has issued final regs that provide guidance on the availability and character of a loss deduction from abandoned securities under Code Sec. 165. The regs, which adopt proposed regs issued in 2007, apply to securities abandoned after Mar. 12, 2008.
Background. If any security that is a capital asset becomes worthless during the tax year, the loss is treated as from the sale or exchange of a capital asset-that is, as a capital loss on the last day of the tax year. (Code Sec. 165(g)(1)) A security is defined as a share of stock in a corporation; a right to subscribe for or to receive a share of stock in a corporation; or a bond, debenture, note or certificate or other evidence of indebtedness issued by a corporation or government with interest coupons or in registered form. (Code Sec. 165(g)(2)) An exception from this capital loss treatment applies for certain worthless securities in a domestic corporation affiliated with the taxpayer. (Code Sec. 165(g)(3))
IRS had learned that some taxpayers had taken the position that a loss from the abandonment of a security was not subject to the loss characterization rules provided in Code Sec. 165(g). (Preamble to Prop Reg)
Abandoned securities. The final regs provide that for purposes of applying the Code Sec. 165(g) loss characterization rules, the abandonment of a security establishes its worthlessness to the taxpayer. A loss established by the abandonment of a security that is a capital asset is treated as a loss from the sale or exchange, on the last day of the tax year, of a capital asset, unless the Code Sec. 165(g)(3) exception applies. While a taxpayer doesn't have to relinquish legal title to property in all cases to establish abandonment, the regs require that to abandon a security a taxpayer has to permanently surrender and relinquish all rights in the security and receive no consideration in exchange for the security. (Reg § 1.165-5(i))
Abandoned or cancelled debt instruments. Generally, the treatment of a worthless debt is governed by Code Sec. 166. However, there's an exception to this rule under Code Sec. 166(e) where a debt is evidenced by a security as defined in Code Sec. 165(g)(2)(C). In that case, based on what IRS stated in Preamble to Prop Reg, the tax treatment of the debt securities is governed by the final regs.