Tax benefits of IRC Sec. 165.

• Author: Siegel, Bart H.
• Position: FederalTaxation

The deduction for theft losses related to nonbusiness, for-profit transactions is one of the best-kept Internal Revenue Code secrets--and a tool that tax professionals can use to provide significant tax relief for their injured investor or taxpayer clients.

SEC. 165: THE MISUNDERSTOOD DEDUCTION

Numerous technical requirements must be met before a taxpayer's loss qualifies for Sec. 165 treatment. And in most instances, tax preparation software does not adequately address this deduction.

Sec. 165 permits advantageous tax treatment as compared to the familiar Sec. 1211 capital loss treatments, which could result in your client paying more taxes than required.

Audit-sensitive tax preparers and taxpayers may be apprehensive about taking this deduction. A loss that qualifies for tax treatment under Sec. 165 frequently qualifies for a large deduction. This may result in a large refund or eliminate taxable income for years to come. Claiming a large deduction or eliminating taxable income sometimes triggers IRS over-sight. For this reason alone, you may be reluctant to use this tax treatment.

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Because clients may not realize that their investment loss was the result of fraud, you should ask about the nature of large investment losses. If you review the client's portfolio and see indications of fraudulent investments or unethical sales practices, advise your client to discuss it with a lawyer. If the lawyer feels there was malfeasance, the client's unrecoverable loss probably qualifies for tax treatment under Sec. 165.

Other losses that may qualify for Sec. 165 treatment include embezzlement, blackmail, kidnapping for ransom, burglary, larceny, extortion and threats.

THEFT LOSS VS. CAPITAL LOSS

A Sec. 165 theft-loss deduction can be more advantageous than a mere capital loss:

* A theft-loss deduction is an ordinary deduction that is not subject to the limitations imposed by Sec. 1211.

* A theft-loss deduction is not a miscellaneous itemized deduction subject to the 2 percent floor imposed by secs. 67(a) and 67(b)3.

* A theft loss is excluded from the phase-out of itemized deductions required by Sec. 68(b).

* A theft loss that exceeds a taxpayer's gross income gives rise to a net operating loss that is not subject to the limitation imposed on nonbusiness deductions of individual taxpayers [Sec. 172(d)(4)(C)]. A net operating loss resulting from a theft loss may be carried back three years or carried forward for 20 years [Sec. 172(b)(1)(A) and 172(b)(1)(F)].

* A theft loss can be used to reduce a taxpayer's tax liability to zero without resulting in any liability for alternative minimum tax [Sec. 56(b)(1)(A)(i) and 67(b)(3)].

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