18.9 Theft Losses
You can deduct a theft loss in the year you discover that your property was stolen. The taking of property must be illegal under state law to support a theft loss deduction. That property is missing is not sufficient evidence to sustain a theft deduction. It may have been lost or misplaced. So if all you can prove is that an article is missing or lost, your deduction may be disallowed. Sometimes, of course, the facts surrounding the disappearance of an article indicate that it is reasonable to assume that a theft took place. A deduction has been allowed for the theft of trees.
If you expect to be reimbursed by insurance, you must subtract the expected reimbursement when you figure your deductible loss (18.13).
A legal fee paid to recover stolen property has been held to be deductible as part of the theft loss. To figure the amount of a theft loss deduction, see 18.13.
Filing Instruction
Fraud by building contractors.
A deduction was allowed when a building contractor ran away with a payment he received to build a residence. The would-be homeowner was allowed a theft loss deduction for the difference between the money he advanced to the contractor and the value of the partially completed house. In another case, a theft deduction was allowed for payments to subcontractors. The main contractor had fraudulently claimed that he had paid them before he went bankrupt.
The Tax Court rejected a theft loss claim that a contractor who failed to meet the construction plan specifications for a home had committed fraud under New Mexico law. The job was completed and repairmen were sent by the contractor to fix defects even after the one-year warranty period had expired. The contractor may have acted negligently or committed breach of contract, but poor workmanship is not fraud.
Embezzlement losses are deductible as theft losses in the year the theft is discovered.
However, if you report on a cash basis, you may not take a deduction for the embezzlement of income you have not reported. For example, an agent embezzled royalties of $46,000 due an author. The author’s theft deduction was disallowed. The author had not previously reported the royalties as income; therefore, she could not get the deduction.
Deduction allowed to victims of Ponzi schemes and similar fraudulent schemes.
The IRS allows investors who fall victim to fraudulent investment arrangements, including Ponzi schemes, to claim a theft loss deduction under special rules (Revenue Ruling 2009-9). The loss is deductible as a theft loss of income-producing property (so the loss is figured in Section B of Form 4684 and the floors for personal-use property in 18.12 do not apply) on your tax return for the year the loss was discovered.
Law Alert
The IRS also provides an optional safe harbor method for computing and reporting the theft loss (Revenue Procedure 2009-20). The safe harbor allows eligible investors to deduct either 75% or 95% of their “qualified investment”, less any actual or projected recovery from insurance, loss-protection arrangement or the SIPC (Securities Investor Protection Corporation). The 75% deduction applies if the investor intends to pursue a third-party recovery and the 95% amount applies if a third-party recovery will not be pursued.
Eligibility for the safe harbor is limited to investors who had a taxable investment account in the fraudulent arrangement and the investment must have been made directly, not through a fund, partnership, or other entity. Losses in IRAs or other tax-deferred retirement plans invested with the scheme do not qualify for the safe harbor.
In addition, a loss is deemed to be the result of theft and therefore eligible for safe harbor relief only if (1) the “lead figure” in the scheme was charged under federal or state law (by way of indictment or information) with fraud, embezzlement, or a similar crime, (2) in response to a federal or state criminal complaint, the lead figure admitted guilt or a receiver or trustee was appointed or the assets were frozen, or (3) the assets of the investment scheme were frozen or a receiver or trustee was appointed after a state or federal agency filed a civil complaint in a court or administrative proceeding alleging a fraudulent arrangement conducted by the lead figure, and the lead figure died before being charged with criminal theft. The loss is deductible for the taxable year in which the theft was discovered (the “discovery year”). Generally, this is the year in which the indictment, information, or complaint against the lead figure was filed. However, if the lead figure died before being charged with criminal theft and a civil complaint under (3) above was filed, the discovery year is the year of the lead figure’s death where that is later than the year that the civil complaint was filed (Revenue Procedure 2011-58).
Fraudulent sales offers.
Worthless stock purchases made on the representation of false and fraudulent sales offers are deductible as theft losses in the year there is no reasonable prospect of recovery. However, the illegal sale of unregistered stock does not support a theft loss deduction. In addition, buying stock from a bad tip and losing money is not deductible.
Kidnapping ransom.
Payment of ransom to a kidnapper is generally a deductible theft loss. However, the expense of trying to find an abducted child is not a theft loss.
Caution
Fortune tellers.
The Tax Court allowed a theft loss deduction in New York, where fortune telling is by law a theft-related offense. The law assumes that telling fortunes or promising to control occult forces is a form of fraud. An exception is made for fortune telling at shows for the purpose of entertaining or amusement. That a person voluntarily asks for advice does not bar the deduction. According to the court, a gullible person who gives money to fortune tellers in the belief that he or she will be helped is still defrauded or swindled. Theft is a broad term and includes theft by swindling, false pretenses, and any other form of guile. In this case, the taxpayer, who was suffering from depression, had become attached to two fortune tellers whom he claimed took him for over $19,000.
Riot losses.
Losses caused by fire, theft, and vandalism occurring during riots and civil disorders are deductible. To support your claim of a riot loss, keep evidence of the damage suffered and the cost of repairs. Photographs taken prior to repairs or replacement, lists of damaged or missing property, and police reports would help to establish and uphold your loss deduction.
Foreign government confiscations.
The IRS and courts have disallowed casualty deductions for confiscations of personal property by foreign governments. This includes deposits in foreign banks; the loss is limited to a short-term capital loss.
Swindled by friend.
A theft loss deduction was allowed to a widow who gave her old beau over $2 million to acquire stock for her in his bank. He used the money to pay his personal debts. The IRS barred the theft loss, arguing that the widow failed to prove fraud. A district court disagreed and allowed the deduction. Under Oklahoma state law, a person who makes a promise in return for cash has committed larceny by fraud if he never intended to return the funds or make good on the promise. Here, that the widow gave him the money voluntarily does not bar a theft loss deduction. She parted with the funds based upon his false claim that he would invest the money for her when he had no intention of doing so, but planned all along to pay off his debts with the funds.