Securities fraud and the theft-loss deduction.

• Author: Chambers, Valrie

Whether investment losses from fraud should be treated as capital losses or theft losses when the stock is purchased through a stockbroker is currently undecided for tax purposes. Many recent court decisions have denied such theft losses citing, in part, a need for direct privity between the victim (taxpayer) and perpetrator of the fraud when a stockbroker is used. However, both Rev. Rul. 2009-9 and Rev. Proc. 2009-20 describe the IRS's position on theft losses from fraud; and that position may be softening.

Depending on the circumstances, losses on investments due to fraud may be treated as a casualty loss, as a capital loss, or as a return of capital. Normally, worthlessness of investments or the loss on their disposal would be a capital loss. Taxpayers would generally not favor having phantom income from a Ponzi scheme classified as a return of capital because the statute of limitation on refunds may have expired for the early years of the scheme and because the courts are divided on this issue. Where a fraud exists, however, the loss may qualify for theft-loss treatment.

To deduct a theft loss, the taxpayer must have something that can actually be taken (like money) rather than the mere (and perhaps false) promise that an asset exists. A reduction in the resale value of property and other indirect effects of thefts would not normally produce a deductible casualty loss. The taxpayer must reduce the amount of a theft loss that the taxpayer actually deducts on the tax return by insurance and other expected reimbursements, if any. Net theft losses are estimated and reconciled to subsequent recoveries. If the taxpayer overestimated expected reimbursements in figuring the casualty loss, the resultant casualty loss understatement should be included as a loss with other losses in the year when the taxpayer can reasonably expect no further reimbursement.

Where a (subsequent) recovery was underestimated, the taxpayer includes the excess recovery over the original estimate in income in the year of recovery to the extent that the original casualty loss deduction reduced the taxpayer's tax in the earlier year. Theft losses on securities are not subject to the $100 floor and 10% of adjusted gross income limitations in Sec. 165(h) because the taxpayer enters into the investment for a profit.

For individuals, capital losses are offset against capital gains in the year a security is sold or becomes totally worthless (Sec. 165(g)). If a net capital loss...