Is taxpayer’s claimed loss due to theft or a bad investment?
Taxpayer Says: The loss was due to a fraudulent scheme, and should be deductible as a theft loss.
Internal Revenue Service Says: No theft occurred, because the taxpayer’s payment was part of a bona fide transaction and she made a bad investment, and the funds are still available to her.
From Internal Revenue Code Section 165(a), (e): Permits a deduction against ordinary income for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” The deduction is allowed for the year the loss is sustained. Generally, a theft loss is treated as sustained during the taxable year in which the taxpayer discovers it.
From Internal Revenue Code Section 165(c): For individuals, the deduction is limited to: (1) losses incurred in a trade or business; (2) losses incurred in any transaction entered into for profit though not connected to a trade or business; or (3) losses of property not connected with a trade or business or a transaction entered into for profit if such losses arise from “fire, storm, shipwreck, or other casualty, or from theft.”
From Jeppsen v. Commissioner, 128 F.3d 1410, 1414 (10th Cir. 1997): Even after a theft loss is discovered, if a claim for reimbursement exists during the year of the loss with respect to which there is a reasonable prospect of recovery, then a theft loss is treated as “sustained” only when it can be ascertained with reasonable certainty whether such reimbursement for the loss will be obtained. Stated differently, a reasonable prospect of recovery will postpone the theft-loss deduction until such time as the prospect no longer exists.
From Edwards v. Bromberg, 232 F.2d 107, 110 (5th Cir. 1956); 26 C.F.R. sec. 1.165-8(d) (2012): The term “theft” under section 165 is a word of general and broad meaning that includes any criminal appropriation of another’s property, including theft by swindling, false pretenses, and other forms of guile.
From Bellis v. Commissioner, 540 F.2d 448, 449 (9th Cir. 1976): Whether a theft loss has been established depends upon the law of the state where the alleged theft occurred.
From Allen v. Commissioner, 16 T.C. 163, 166 (1951): A taxpayer must prove a theft occurred under applicable state law by only a preponderance of the evidence and not beyond a reasonable doubt. (“If the reasonable inferences from the evidence point to theft, the proponent is entitled to prevail. If the contrary be true and reasonable inferences point to another conclusion, the proponent must fail.”).
From Monteleone v. Commissioner, 34 T.C. 688, 694 (1960): A criminal conviction is not necessary in order for a taxpayer to demonstrate a theft loss.
From Tex. Penal Code Ann. sec. 31.03(a) (West 2011 & Supp. 2012): THEFT. (a) A person commits an offense if he unlawfully appropriates property with intent to deprive the owner of property. Provides that “[a]ppropriation of property is unlawful if: (1) it is without the owner’s effective consent”. Consent is not effective if it is induced by deception. Under Texas law, a theft took place if someone appropriated the money by deceit and intended to deprive the owner of the property.
THE CAUSE OF THE DISPUTE
In general, with certain limitations, you can claim a theft loss as an itemized deduction on your individual income tax return in the year you discover your property was stolen. In contrast, investment losses are treated as capital losses, and you can deduct up to $3,000 per year in excess of any capital gains you may have.
Disputes arise because the tax treatment between the two types of losses depends on facts and circumstances, as well state law, and the difference between a theft loss and an investment loss may not always be clear. (See Revenue Ruling 2009-9 for a detailed explanation.)
In this case, in 2006, on behalf of a friend, the taxpayer transferred $181,104 to a Swiss bank account in an attempt to make money through a bank-guaranty transaction. She was told that if she made the payment, she would receive $2.5 million; that the first installment of the $2.5 million would be paid two weeks after the payment; and that the money would be returned at any time upon request.
None of the promises were kept. During 2007, after multiple delays and evasions by the person who made the promises, the taxpayer’s friend contacted authorities, but was unable to recover the money.
The taxpayer filed a 2007 tax return, but did not claim a theft loss deduction. In 2009, when the IRS began an examination of her return (for unspecified reasons), the taxpayer hired an accountant, who in turn hired a lawyer to investigate her options regarding the theft loss.
The lawyer contacted both the taxpayer’s friend, and the person who made the promises regarding the transaction. The lawyer also contacted US authorities, and received no cooperation from them. He concluded it would be cost prohibitive for the taxpayer to file a civil suit against the person who convinced her to enter into the transaction, explaining that the person did not have any recoverable assets, the costs of suing him would be expensive, and it was “risky” whether the taxpayer could prove that person received the money. The lawyer also considered the possibility the taxpayer could sue her friend, but informed her such a suit would not result in recovery of the money.
When the IRS issued a deficiency notice as a result of their examination, the taxpayer filed a tax court petition to claim a theft loss, saying she had entered into a fictitious transaction, and she knew by the end of 2007 that she would not get her money back.
The IRS says the loss was not a theft loss, because the taxpayer did not prove any person appropriated the money with the intent to deprive her using deception. Instead, the payment was “part of a bona fide transaction” and “this was just a bad investment or the funds are still available to the taxpayer.” The IRS pointed out there is no evidence the taxpayer’s attorney attempted to contact the companies promoting the transaction to verify that the transaction was fraudulent. The IRS also pointed out there is no evidence criminal charges were filed against the person who convinced the taxpayer to enter into the transaction.
The IRS believes there are several alternative ways to reach the conclusion the purported bank-guaranty transaction was not fictitious. First, the taxpayer could have been investing in a heretofore undeterminable credit investment in Europe based on negotiations between her friend and the person promoting the transaction. Second, the taxpayer may have loaned money to her friend to invest in the undeterminable credit investment in Europe and would be paid back by monies received by her friend. Third, the taxpayer may have transferred money to an investment account in Europe and the money may, or may not, be there. The IRS says there is no way to determine what occurred from the record.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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