In considering the various options of recovery available for tax losses some fundamental knowledge of the law is important. We are going to cover those fundamentals into the following order.
1. The Amount of the Theft Loss Deduction
2. The Timing of the Theft Loss Deduction
3. Tax Loss Carry Backs and Tax Loss Carry Forwards
4. Deduction in the Year of Loss
5. Deduction in Years Other Than the Year of Loss
6. Other Sources of Tax Recovery
7. Payments Received as a Return of Capital – Not Income
8. “Phantom Income” Tax Treatment
9. Tax Planning and the Practical Effects of the Tax Rules – Mistakes to Avoid.
The Amount of the Theft Loss
To result in a tax loss the lost asset must have a tax basis.
If the theft is accomplished in a manner that results in the taxpayer’s failure to include the lost asset in income or if a taxpayer has claimed the amount of the loss as a different type of deduction no theft loss will be allowed. In such a case, there should be no deduction because the lost property would have a zero tax basis.
An example would be losses suffered by an IRA or other deferred compensation plans where the amounts deposited into the plan for the beneficiary have never been included in the beneficiary’s income. There is no tax basis by the beneficiary in any of these funds.
Furthermore, it is recognized that costs such as legal fees incurred in collecting on Ponzi schemes were deductible as a theft loss. Courts have found that these costs and others such as the costs of recovery or salvage are so closely identified with the theft loss itself as to add further theft losses.
The Timing of the Theft Loss Tax Deduction:
The basic rules governing the theft tax loss deduction are straight forward:
The theft loss deduction is a deduction of ordinary income
The theft loss deduction may be carried back three (3) years and carried forward twenty (20) years.
When it comes to the proper timing of the theft loss deduction it gets more complicated. The basic rules that govern the proper year that the theft loss deduction should be claimed as a deduction are as follows:
A tax deduction is allowed for any theft loss sustained during the taxable year and not compensated for by insurance or otherwise.
A theft loss is treated as sustained during the taxable year in which the taxpayer discovers the loss.
However, a theft loss is not deductible in the taxable year in which the theft was discovered to the extent that a claim for reimbursement exists and there is a reasonable prospect of recovery of the loss.
If a theft loss cannot be deducted in all or any portion the year of discovery because a reasonable prospect of recovery of the loss exists, then the theft loss deduction must be taken in the year (s) that it can be ascertained with a reasonable Certainly that no further recovery will be received.
If the taxpayer deducts a theft loss in the year of discovery because no reasonable prospect of recovery exists at that time and the taxpayer later receives compensation or reimbursement, the compensation or reimbursement does not cause a re-computation of the deduction; instead it is included in gross income for the year received.
The effect of these phrases on the appropriate timing of a theft loss deduction is as follows:
A taxpayer who suffers a theft loss should take that theft loss deduction in the year the loss is sustained, which is in the taxable year in which the taxpayer discovers the loss. However, if in the year the taxpayer discovers the loss there is a reasonable prospect of recovering all or some portion of the loss, the taxpayer must postpone taking the theft loss deduction to later years; unless the taxpayer can show that as to all or some portion of the loss there is no reasonable prospect of recovery.
If the taxpayer does not take a theft loss deduction in the year of discovery, in the following years the taxpayer may not take a theft loss deduction until the year in which the taxpayer can ascertain with reasonable certainty whether the expected reimbursement will in fact be received or not.