Reports of Ponzi-schemes and other investment scams are all over the news. Fortunately for victims of such schemes, the Internal Revenue Code gives certain taxpayers some relief. The law surrounding theft losses is extremely complex. As with any complicated tax matter, do not hesitate to contact a federal tax attorney.
Q: What is a “theft loss” deduction, and how might I qualify for one?
A: The Internal Revenue Code allows you to take what is called a “theft loss” deduction if you have lost money due to investment fraud. To qualify for the deduction, however, you must have suffered a loss on an investment made for profit. Casualty losses and business losses may qualify for separate deduction, but are subjected to limitations not placed on theft losses.
Q: Does an investment in a traditional IRA qualify for a theft loss deduction?
A: An investment in an IRA may qualify. Your investment generally must have been made with already-taxed funds in order for you to qualify, and funds placed in a traditional IRA are not taxed. Recent changes to the tax code do allow for special treatment of losses in traditional IRAs, but the requirements are complex and beyond the scope of this article. You should consult with a federal tax attorney.
Q: What type of documentation do I need to prove I was a victim of investment fraud?
A: The IRS prefers cancelled checks or comparable items, but circumstantial evidence such as company statements or loan documents could be sufficient. Taxpayers with a more thorough record of their investments have an easier time proving the amount of their loss, so you should retain documentation. Since banks generally retain records for only seven years and are constantly merging, it is important to obtain this documentation from your bank as soon as possible.
Q: Is a theft conviction necessary for me to claim my loss?
A: A criminal conviction is not necessary; an indictment for theft likely will be sufficient. Convictions for crimes other than theft (such as securities fraud) can also be enough to support your claim.
Q: I bought stock on the open market and the CEO of the company was later indicted for theft of investor funds. Does my loss qualify?
A: No. You must have dealt directly with the company with which the CEO was associated in order for your loss to qualify. Investments made through a broker or an investment advisor typically do not qualify.
Q: What is the proper year to take my loss?
A: You can typically claim your loss in the year you discover it. Be sure to retain documentation such as press releases, newspaper articles, and court documents showing the year you actually discovered your loss.
Q: The company has filed bankruptcy. Will that affect the year I can take my loss?
A: The year you discover your loss may not always be the proper year to claim your loss. If you have a claim for which there is a “reasonable prospect” of recovering a portion of your loss, you cannot deduct any portion of your loss covered by that claim until you are reasonably sure you will not recover any of your loss.
Generally, the IRS does not appear to consider the surrounding circumstances (e.g., statements made by the trustee) when determining whether a taxpayer has a reasonable prospect of recovery. Instead, if a taxpayer has a pending bankruptcy proof of claim or is participating in litigation, the IRS tends to treat that taxpayer as having a reasonable prospect of recovery for the entire portion of the loss covered by such claim or litigation. Even if such claims exist, deductions may still be approved if recovery cannot reasonably be expected, since the law does not require taxpayers to be “incorrigible optimists.”
Q: Is my theft loss deduction subject to the limitations placed on casualty losses?
A: No. Your entire theft loss amount is deductible on Schedule A. It is not subject to limitations based on a percentage of your adjusted gross income or on a specific dollar threshold.
Q: Does the IRS provide information to help me determine if my loss might qualify?
A: Yes. The threshold for proving theft losses is high and taxpayers must prove their loss qualifies for deduction. Fortunately, in 2009 the IRS published guidance through a revenue ruling and a revenue procedure. The procedure creates a “safe harbor” that eliminates some of the “traditional” theft loss requirements and eases the burden of some of the remaining requirements.
This “Law You Can Use” column was provided by the Ohio State Bar Association (OSBA). It was prepared by Columbus attorney Christopher C. Camboni.