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A friend bounced this question off me the other day and I don't know the answer. I asked TMFSelena and she was stumped as well.

Let's say I short a company 1000 shares @ $10/share. I now have roughly $10,000. The company hits hard times and ends up in Chapter 7 bankruptcy....the stock goes to $0.

Do I have to ever cover? What's the price? If I don't cover when do I recognize the income for tax purposes?

Anyone out there know the rules on this?
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Fun question. The Foolish brothers referred to "never covering" in their investment book but it does present an interesting situation. In this litigious society, I wouldn't be surprised to hear lawyers argue you owe something to those LTBH souls who held to and through Chapter 7 as they try to recover what little might be left of book value. ;>)
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The problem is that when a company goes into bankruptcy there is no market for the securities (the company gets delisted from whatever exchange it's on), so it's hard to see how you could "cover". Also, equity holders typically get zilch in a bankruptcy. After all, the reason why a company goes bankrupt is because liabilites exceed assets.
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First please note that chapter 7 is rare for a publicly traded company, usually it is an 11.

A 7 is a liquidating bankruptcy. Once the company has been liquidated, your common ceases to exist, so at that point you must recognize the gain for tax purposes.

A chapter 11 is a reorganization, not a liquidation. In many chapter 11 cases the existing common stock is cancelled and new common stock issued to creditors. The cancellation of the common stock would trigger recognition of gain for tax purposes.

The fact that a company has been delisted is of no consequence with regard to tax recognition because it will still trade on the pinks.
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Wouldn't the broker come after you for the money, since the broker "lent" you the shares to sell short?
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Right, but if there are no shares to buy to cover because the shares are basically no value...you can't cover.

I think the guy who posted about the different types of bankruptcy is probably closest. Although, in case of Chapter 11 you probably buy to cover at about .01/share. Lots of brokers will buy Chap 11 company shares at that price as a low cost gamble that the company will emerge or get purchased (like Ames did with Jamesway a few years back).

...k
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