US Taxpayers who lose funds due to “fraud” may declare an income tax deduction for their theft loss in the tax year they discover the theft loss (see: IRC sec. 165(c)(3), 165 (e) (1). For IRS audits, it is not required that the affected Taxpayer recover their “fraud losses” only that they pursue collection of their lost funds (by lawsuit, or otherwise). Under IRC Sec. 111, in the event the Taxpayer recovers any of their lost funds they must declare the recovery as income in the tax year received.
As an income tax planning strategy, a “theft loss” may generate: tax savings, tax refunds, tax-free income:
1) In 2014, the maximum California/Federal “blended tax rate” is approximately 55%. So if the fraud loss is $10m, the income tax savings may be as high as $5.5m;
2) Tax Refunds: Under IRC Sec. 172 (b) (1) (F), the theft tax loss may be “carried back” for 3 years (by filing form 1040x for those tax years) with any income taxes paid ( during the 3 prior carry back years) subject to refund;
3) Tax-free Income: The Tax Loss for theft may be carried forward for up to 20 years under IRC Sec. 172, offsetting any taxable income, creating tax-free income up to the amount of the theft loss.
Theft is the illegal taking of money or property with the intent to deprive the owner of it. (W. Lafave, Criminal Law section 8.5, at 721 (2d Ed. 1986)). Theft includes, but is not limited to, larceny, embezzlement, and robbery. (Reg. Section 1.165-8(d)).
California Penal Code Section 484(a)
Taxpayer is a resident of the State of California. Under State Law, California Penal Code Section 484(a) theft is defined to include fraud:
Every person who shall feloniously steal, take, carry, lead, or drive away the personal property of another, or who shall fraudulently appropriate property which has been entrusted to him or her, or who shall knowingly and designed by, any false or fraudulent representation or pretense, defraud any other person of money, labor or real or personal property, or who causes or procures others to report falsely of his or her wealth or mercantile character and by thus imposing upon any person, obtains credit and thereby fraudulently gets or obtains possession of money, or property or obtains the labor or service of another, is guilty of theft.
Gerstell v. Commissioner of IRS (Federal Law)
In the case of Gerstell (Petitioner) v. Commissioner of Internal Revenue (Respondent) 46 T.C. 161 (Docket No. 4299-64, filed May 4,1966) (Exhibit “2”), the Tax Court States (at Page 7):
Section 165 of the Internal Revenue Code of 1954 provides for the deduction of losses arising from theft. The term Theft . . . converting any criminal appropriation of another’s property to the use of the taker, particularly including theft by swindling, false pretenses, and any other form of guile.
Edwards v. Bromberg (C.A. 5) 232 F. 2d 107, Perry A. Nichols, 43 T.C. 842 (appeal dismissed C.A. 5) See also Sec. 1.165-8(d), Income Tax Regs. The parties are not at odds on this respect. Indeed, the Respondent concedes on brief that losses sustained by reason of criminally false pretenses are deductible under Section 165 of the Code. Whether a loss arises from theft depends upon the law of the jurisdiction where the loss was sustained. Edwards v. Bromberg, supra.
And it has been held that a criminal conviction is not a necessary element in a Taxpayer’s proof that a theft loss has been sustained.
See: Michele Montelone 34 T.C. 688
Paul C.F. Vietzke 37 T.C. 504
Statement of Law: Theft Losses (Summary)
IRC § 165(a) provides as a general rule that “any loss sustained during the taxable year” may be deducted if it is not compensated for by insurance or otherwise. Section 165(a), however, limits this broad rule by restricting an individual’s deductions to:
1. Losses incurred in a trade or business or a transaction entered into for profit; and
2. Losses “from fire, storm, shipwreck, or other casualty, or from theft.”
The “theft loss,” which only includes losses to property not connected with the taxpayer’s trade or business or for-profit transactions, and is further restricted by rules denying the deduction for the first $500 (2009)of loss from each casualty and allowing losses above this floor only to the extent they exceed 10 percent (10%) of adjusted gross income (IRC §165(h)). The courts have found a further limitation implicit in Section 165(a) – that a casualty loss is not allowable in any part if the deduction would frustrate well-defined public policy.
(See, Blackman v. CIR, 88 TC 677, 682 (1987) – taxpayer intentionally set fire to wife’s clothes and negligently allowed fire to spread to entire house; held no casualty loss deduction because deduction “would severely and immediately frustrate the articulated public policy … against arson and burning,” even though taxpayer never charged with crime; Mazzei v. CIR, 61 TC 497 (1974) – taxpayer defrauded by co-conspirators in scheme to counterfeit U.S. currency; held, theft loss of participant in criminal activity not deductible; Rev. Rul. 82-74, 1982-1 CB 110 (where taxpayer, in order to collect insurance, paid another to burn down taxpayer’s building, public policy, precludes amount paid from being taken into account in determining gain on building’s conversion). However, see, Hossbach v. CIR, 42 TCM (CCH) 80 (1981) [public policy not offended by allowing deduction for destruction by explosion of building used by taxpayer to manufacture illegal drugs]. IRC § 641(b) rules make § 165(c) apply to trusts and estates.)
Since losses attributable to business and profit-oriented property are deductible regardless of cause, the principal significance of the deduction allowed by § 165(c)(3) for casualty losses is that it encompasses personal residences, private automobiles, jewelry, home furnishings, and other property owned and used for personal purposes. Property of this type does not qualify for depreciation deductions while the taxpayer owns it, and losses on sales of such property are also nondeductible. (Reg. § 1.165-9(a).) If the property is damaged or destroyed by casualty, however, the resulting loss may be deducted under § 165 (c)(3).)
Taxpayer Theft Loss Deduction
Under IRC §165, an individual may deduct losses arising from “fire, storm, shipwreck, or other casualty or from theft.”
Under IRC §165(c)(2), an individual may deduct theft losses involving a transaction entered into for profit.
Under IRC §165(c)(3), an individual may deduct losses due to theft (see Treas. Reg. Section 1.165-8(d)).
A loss arising from theft is treated as sustained during the taxable year in which the Taxpayer discovers the loss (IRC §165(e)(1)).
The deductible amount is the lesser of the fair market value or basis of the property stolen (Treas. Reg. §1.165-8(c)), IRC §165(b).
An individual is permitted to deduct losses to her property arising from “fire, storm, shipwreck, or other casualty, or from theft.” The term “other casualty” defined as a sudden, unexpected event that is unusual in nature and beyond the control of the taxpayer.
A theft loss technically is not a casualty loss, but theft losses are aggregated with casualty losses for most purposes. The first $500 (2009) of each personal casualty or theft loss is not deductible, and personal casualty and theft losses are generally deductible only to the extent they exceed 10 percent of the taxpayer’s AGI.
Casualty and theft losses that arise in a trade or business or activity engaged in for profit are deductible (as are other losses arising in these activities) and may qualify for beneficial treatment under Code Section 1231.
The portion of a loss that is reimbursed by insurance is not deductible (Code Section 165(a)). A personal casualty or theft loss is deductible only if the taxpayer files a timely claim for any insurance covering the loss. Code Section 165 (h) (5) (E).
Taxpayers claiming casualty and theft losses must file Form 4684, Casualties and Thefts, with their tax returns to claim the deduction. The IRS has also made available two workbooks, IRS Publication 584, Casualty, Disaster, and Theft Workbook, and IRS Publication 584B, Business Casualty, Disaster, and Theft Workbook, which contain schedules used to compute personal and business casualty and theft losses, respectively.