Federal tax law permits taxpayers to deduct so-called “theft losses,” provided certain requirements are met. Initially, a taxpayer must show that he or she will not receive compensation through insurance or another third party for the loss. If this threshold is met, the taxpayer must overcome additional hurdles, including showing: (1) the occurrence of a theft; (2) the amount of the theft; and (3) the date the taxpayer discovered the theft. As discussed more fully below, these requirements are not always so easy to meet.
The Occurrence of a Theft
Common sensically, a taxpayer must first show the existence or occurrence of a theft to sustain a theft loss deduction under Section 165 of the Code. For these purposes, theft is “deemed to include, but shall not necessarily be limited to, larceny, embezzlement, and robbery.” Treas. Reg. § 1.165-8(d); see also Littlejohn v. Comm’r, T.C. Memo. 2020-42 (“As used in section 165, the term ‘theft’ is a word of general and broad connotation, intended to cover any criminal appropriation of another’s property, including theft by larceny, embezzlement, obtaining money by false pretenses, and any other form of guile.”). Moreover, according to the IRS and a majority of the federal courts:
[T]o qualify as a ‘theft’ loss within the meaning of Section 165[ ] of the Code, the taxpayer needs only to prove that his loss resulted from a taking of property that is illegal under the law of the state where it occurred, and that the taking was done with criminal intent.
Rev. Rul. 72-112, 1972-1 C.B. 60; see also Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956); see also Citron v. Comm’r, 97 T.C. 200, 207 (1991) (“The law of the jurisdiction where the loss is sustained is applicable to determine whether a theft or embezzlement has occurred.”). This rule applies even where the theft was deemed to occur in a foreign jurisdiction. See First Chi. Corp. & Affiliated Corps. v. Comm’r, T.C. Memo. 1995-109 (applying Brazilian criminal law and holding that taxpayer was entitled to a theft loss deduction); Williams v. Comm’r, T.C. Memo. 1985-201 (applying Costa Rican criminal law to determine whether taxpayer qualified for theft loss deductions under Section 165), aff’d, 786 F.2d 1170 (8th Cir. 1986).[i]
Federal case law makes it clear that taxpayers bear the burden of demonstrating that a theft occurred under applicable state or foreign law. Sometimes, this is not an easy thing to prove. See, e.g., Bruno v. Comm’r, T.C. Memo. 2020-156; Guinta v. Comm’r, T.C. Memo. 2018-180. For example, in Guinta, the taxpayer contended that he had lost $2.5 million due to an alleged foreign Ponzi scheme. At trial, the taxpayer even offered evidence of the investment agreement in conjunction with his testimony that he lost the funds. Nevertheless, the Tax Court held that he was not entitled to the theft loss deduction because he was unable to show a theft occurred under applicable law (New York or U.K.) or even which law should apply.
In many theft loss cases, the taxpayer may believe that a theft has occurred, but may be unable to identify the thief or thieves. Although there is federal case law to support a position that a taxpayer is not necessarily required to do so to support a theft loss, see Leslie v. Comm’r, T.C. Memo. 2016-171, a taxpayer may find the burden to show theft without this evidence insurmountable, see Guinta, T.C. Memo. 2018-180. The same rationale applies if the taxpayer has not reported the theft loss to law enforcement or if the taxpayer is unable to show a thief was convicted criminally for the theft. See, e.g., Vincent v. Comm’r, 219 F.2d 228 (9th Cir. 1955); Moser v. Comm’r, 18 T.C.M. 116 (1959).
The Amount of the Theft
In addition to proving the occurrence of a theft, a taxpayer must further show the correct amount of the theft loss for federal income tax purposes. Generally, the amount of the theft loss is limited to the basis of the stolen property. Raifman v. Comm’r, T.C. Memo. 2018-101; Treas. Reg. §§ 1.165-7(b)(1), -8(c). Moreover, for purposes of determining the amount of the theft loss, the regulations assume a deemed sale under Treas. Reg. § 1.1011 where “the fair market value of the property immediately after the theft shall be considered zero.” Treas. Reg. § 1.165-8(c).
The requirement to show the amount of the theft loss is often overlooked and deceptively simple. To prove this requirement, taxpayers should have good books and records or other documentary evidence to reflect the basis and fair market value of the property at the time of the theft. If the taxpayer is unable to do so, the taxpayer runs the risk of having the entire theft loss denied.
The Timing of the Theft Loss Deduction
A final requirement to claim a theft loss deduction under Section 165 is that the taxpayer must show the tax year in which the loss occurred and that there is no reasonable prospect of recovery in that same year. See I.R.C. § 165(e). Generally, the year of the discovery is the year in which a reasonable person in similar circumstances would have discovered the theft loss. Cramer v. Comm’r, 55 T.C. 1125, 1133 (1971). If there is a reasonable prospect of recovery in the year of the discovery, the timing of the deduction is delayed until the prospect of recovery no longer exists. Treas. Reg. § 1.165-1(d)(3). Whether a reasonable prospect of recovery exists is determined by an examination of all of the facts and circumstances including any settlement of the claim, any adjudication of the claim, and any abandonment of the claim. Treas. Reg. § 1.165-1(d)(2); Baum v. Comm’r, T.C. Memo. 2021-46.
Generally, the determination as to whether there is a reasonable prospect of recovery is based primarily on objective factors; the taxpayer’s subjective belief may also be considered, but that is not the sole or controlling criterion. Baum, supra. Significantly, the taxpayer is not required to pursue every avenue of recovery, particularly those with only a remote possibility of success. Adkins, 960 F.3d at 1365 (Fed. Cir. 2020).
Out of all of the requirements, this one tends to be the more litigated by the IRS. This is so because it is factually intensive and, if the IRS is successful in demonstrating another year in which the taxpayer should have claimed the theft, the taxpayer can lose the deduction entirely. See Giambrone v. Comm’r, T.C. Memo. 2020-145, discussed here. Accordingly, taxpayers should carefully analyze their particular facts and circumstances to ensure that, prior to claiming the deduction, they are comfortable that the theft loss occurred in that year and that there is no reasonable prospect of recovery in that same year.
Theft loss determinations for tax purposes are not always easy. Even aside from the numerous requirements above, Congress has made it more difficult for taxpayers to claim certain theft losses due to recent revisions in the law that completely disallow theft losses. See I.R.C. § 165(h)(5). Careful analysis of the law in addition to the facts is warranted prior to claiming a theft loss deduction on a tax return. A failure to exercise caution may result in a complete disallowance of the theft loss deduction and significant penalties for the tax reporting.
Freeman Law aggressively represents clients in tax litigation at both the state and federal levels. When the stakes are high, clients rely on our experience, knowledge, and talent to help them navigate all levels of the tax dispute lifecycle—from audits and examinations to the courtroom and all levels of appeals. Schedule a consultation or call (214) 984-3000 to discuss your tax needs.
[i] At least one federal court has refused to look to applicable state or foreign law to determine whether a theft occurred under Section 165. See Goeller v. U.S., No. 1:10-cv-00731-FM (Fed. Cl. Mar. 20, 2013). However, subsequent federal court decisions—including Tax Court decisions—have continued to apply relevant state or foreign law to make this determination. See, e.g., Rochlis v. U.S., 146 Fed. Cl. 743 (Fed. Cl. 2020).