Better to Abandon a Bad Investment Than to Sell It? Sometimes, if the Investment is Still Worth Something
Could it be better to abandon a bad investment and receive nothing in return, than to sell it and receive something in return? Sometimes the answer is “yes,” according to a recent federal appellate court decision. The reason is that you can take an ordinary business tax loss from abandonment even though a sale would produce a capital loss. The extra tax benefit from the ordinary business loss may be more valuable to you than the combined consideration and capital loss you receive from a sale.
Assume you bought an investment for $100, and its value has fallen to $2. If you sell the investment for $2 and the investment is a capital asset, you will recognize a $98 capital loss. Unless you have $98 of capital gains from other transactions available at that time, you can’t use the loss to offset other income, and you are left with the $2 of sale proceeds. Even if you have $98 of capital gains from other transactions, an individual might offset capital gains tax at a 23.8% tax rate, producing a $23.32 tax savings, and a total value of $25.32, including the $2 of sale proceeds. If you abandon the investment for no consideration, you may be able to take a business loss offsetting income otherwise taxable at a 43.4% tax rate, producing a $42.53 tax benefit. Bizarrely, the $42.53 tax benefit from the ordinary business deduction is worth substantially more than the $25.32 combined proceeds and capital loss tax benefit from a sale.
Even more bizarrely, thanks to a quirk in the Internal Revenue Code, this arbitrage is not possible when the investment is completely worthless. It is only possible when the investment has some remaining value.
This arbitrage only exists in limited circumstances and does not work for all investments. It also has litigation risk. The Tax Court has held that it does not work. The Fifth Circuit Court of Appeals decision approving the strategy is only binding law to overturn the contrary Tax Court decision in Texas, Louisiana, and Mississippi. The IRS may still challenge the strategy for taxpayers in other states, and those taxpayers cannot be sure their own federal appellate court will agree with the Fifth Circuit. For those willing to take those risks, however, the strategy is compelling.
Here is a link to the Fifth Circuit Court of Appeals February 25, 2015, decision in Pilgrim’s Pride v. Commissioner, approving the strategy: