Shorting the stock of a company that goes bankrupt is like winning the lottery. The money you receive for shorting the stock is all yours, though there might be some delay in freeing it from the broker's grip -- it holds the money as collateral until it writes off the loan. You'll owe capital gains tax on your profit unless you shorted the stock within an individual retirement account.
Shorting a Stock
Stock shorting is a bearish strategy -- you make money if the stock loses value. You begin by borrowing shares from your broker and selling the shares on the open market. The broker will hold your proceeds as collateral. At some point, you will have to repay the shares you borrowed from the broker. Normally, you do this by entering the marketplace and purchasing the shares at the current price. Your gain or loss is the price difference from the original sale and the subsequent purchase. The broker releases your collateral when you return the shares.
The Bankruptcy Jackpot
A company may reach bankruptcy through a long slide or a quick implosion. If you had warning, you might have closed out your short by repurchasing the shares for a few pennies, returning them to the broker and retrieving your collateral. But if the company goes under before you cover your short, you will probably have to be patient as the courts liquidate the company to pay off the investors. When the court declares the bankruptcy, it cancels any shares still trading and the exchange delists the stock if it hasn't already done so. The stock is no more -- it has ceased to exist.
Repaying the Loan
Your broker will eventually declare a complete loss on the stock loan and cancel your debt. Only then will the broker release your collateral and stop charging you interest on the loan. As a stockholder, your broker may receive some money after the government, creditors and preferred stockholders squeeze as much as possible from the company liquidation. However, most likely your broker will recover little or nothing. By this time, if the stock had ever been part of an index, it’s long since been replaced.
The Internal Revenue Service requires you to declare your capital gain as soon as the stock becomes "substantially worthless." Your capital gain is short term -- taxed at your marginal rate -- since you never owned the stock. If the stock price has dropped to a few pennies per share as the year ends, you might want to recognize the gain before the new year, even if the firm is not yet formally bankrupt -- you don't want the good folks at the IRS accusing you of delaying payment of your taxes. You report the gain on IRS Form 8949 as if you had covered the short sale at a price of zero. You also report the gain on Schedule D and on Form 1040 or one of its variants.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.