Section 1244 of the Internal Revenue Code provides an interesting benefit – ordinary loss treatment for the sale of stock. Generally losses (and gains) are subject to lower capital gain tax rates. This is a great thing when you’re selling stock for a gain. Not so much when you’re selling stock at a loss. So what is Sec 1244 stock? And how do you get in on this deal if you’ve sold stock at a loss? I’m glad you asked… Let’s dig into how you can claim ordinary losses for Sec 1244 stock!
Selling Stock at a Loss
But before we dig into Sec 1244 stock, let’s discuss what normally happens when you sell a stock at a loss. When you sell large company stock, mutual funds or ETFs, you’re allowed to net your capital losses and gains together. If the net number is a gain, you’ll pay capital gain rates on the income. The rate will either be your marginal (ordinary 10%-37%) income tax rate or your lower capital gain rate of 15% or 20% depending on how much other income you earned.
When the net of your sales is a capital loss, you are allowed to deduct up to $3,000 in excess capital losses over gains and net against your ordinary income. The remaining capital losses are allowed as a carryforward item. The carryforward can be used to offset capital gains in future years or at $3,000 per year until they are extinguished.
So What is So Special About Sec 1244 Losses?
Sec 1244 losses are allowed to be deducted against your ordinary income up to $50,000 per year (single) or $100,000 (joint). The mechanism works similarly to the $3,000 loss carryover above, but the limits on the deduction are greatly expanded.
If your loss is greater than $50,000 single or $100,000 joint, the remainder of the loss defaults back to the normal capital loss rules described above.
So How Can You Get in on the Special Rules for Sec 1244 Stock?
Like all good things from the IRS (that sounds odd doesn’t it?), there are special rules to follow to qualify stock for this treatment.
- The corporation must be a small business corporation – a domestic (US) corporation, including S Corporations, can be small business corporations provided that the stock they have issued does not exceed $1,000,000 cumulatively.
- Stock must be issued for cash or property – not services.
- Stock only qualifies when issued directly to the original owner – stock purchased from the initial owner doesn’t qualify.
- Stock issued can be common or preferred stock – provided the preferred stock was issued after 1984.
- In the year that the corporation has surpassed the $1,000,000 limit of issued stock – an election can be made to identify the specific shares that qualify. Absent this election, the Sec 1244 benefit is prorated amongst all shares issued in the year in question.
- Gross receipts test – while the rules are complicated here: (Sec. 1244(c)(1)(C)), the corporation must be an operating company and not be relying on royalties, interest or other passive income.
While rules are complex for Sec 1244 stockholders, this unique Section of code provides a valuable benefit for certain transactions. If you’ve invested in a failed small business in the past, you might want to consider the Sec 1244 rules. Keeping good documentation from the outset is important. And if you’ve sold Sec 1244 stock at a loss in the past three years, you’re in luck. You can still file an amended return to recover the benefit.