When most people receive an e-mail from a Nigerian prince who is in need of assistance with his inheritance, they either delete the e-mail without fully reading it or read it, chuckle, and then delete it. Nonetheless, many taxpayers still fall victim to con artists, internet fraud, and a panoply of other schemes. In addition to these unfortunate souls, many sophisticated individuals fall victim to more elaborate frauds or forms of deceit. The Madoff scandal, the Bayou scandal, and many other investment scandals caused profound financial damage to taxpayers one would normally view as sophisticated. What links all of these together is the fact that the taxpayer suffered a real economic loss and is left feeling that they have been robbed.
What adds insult to injury for so many of these taxpayers is that, unlike a business, they cannot simply deduct losses for the events described above. Individuals can only offset their ordinary income with losses that: (i) are incurred in a trade or business ; (ii) are incurred in any transaction entered into for profit , though not connected to a trade or business; or (iii) are casualty losses (e.g. theft and fire). These three options are subject to myriad restrictions and caveats. Other types of losses are available, but they are typically capital losses that do little good for most individual taxpayers, such as losses for nonbusiness bad debt and worthless securities.
I. Theft Losses
In most cases, taxpayers want to take a theft loss. Theft loss deductions must satisfy two separate tests. The first is whether there was in fact a theft; and the second is whether the converted property was used in a trade or business, held for investment purposes, or simply owned for personal use.
A. What Constitutes a Theft?
Section 165 does not define what constitutes a theft for federal income tax purposes. The regulations offer a modicum of additional information, stating that “the term ‘theft’ shall be deemed to include, but shall not necessarily be limited to, larceny, embezzlement, and robbery.” Case law has clarified that the term “theft” is to be “broadly interpreted for the purposes of Section 165,” and that it covers “a broad field of illegality, including…’swindling, false pretenses, and any other form of guile.’”
The Service takes the position that this means the theft must be illegal in the jurisdiction in which it occurred and done with criminal intent. Although criminal intent is a requirement to take a theft loss, a criminal conviction is not. In other words, giving money to a grossly incompetent investment adviser who charges astronomical fees for atrocious advice to grossly mismanage money (and perhaps even charges fees for low quality investment conferences in beautiful beach locales) would not necessarily count as theft, even if a taxpayer felt as though he or she had been “robbed,” because the investment adviser may not have had criminal intent.
Finally, one often overlooked factor is that the theft must be direct. In other words, the taxpayer’s property must have been stolen. The fact that a taxpayer’s property becomes worthless because of a related theft or fraud does not in and of itself generate a theft loss for an individual. Thus, a taxpayer who invests in a corporation whose stock becomes worthless after it is discovered that the CFO is embezzling money will generally be unable to take a theft loss.
B. When Can an Individual Take a Theft Loss?
Theft losses are treated as sustained during the year the taxpayer discovers the loss, as opposed to when the loss actually occurs. Further, a theft loss can only be taken when there is no “reasonable prospect of recovery” and when it can be “ascertained with reasonable certainty that no recovery or reimbursement will be received with respect to the stolen property.” There will generally be some recovery for stolen property (from insurance or otherwise), but when the taxpayer has “ascertained with reasonable certainty” that there will be no further recovery, the taxpayer may take his or her loss.
