Most people are victims of theft at some point in their lives. To help mitigate the financial devastation this often entails, the IRS permits taxpayers to take theft loss deductions on their tax returns.
Under 26 U.S. Code 165(e), tax deductions can be claimed for losses connected with a theft. As usual, there are a few restrictions:
- The taxpayer must take reasonable steps to recover the stolen item prior to claiming the theft deduction
- The deduction must be made in the year that the theft occurred, or in the tax year in which it can be ascertained with “reasonable certainty” that reimbursement will not be received from an insurance claim or third party
- The value of the item stolen must be substantiated by “credible evidence”
- If the deduction is being claimed for theft from investment fraud, the taxpayer must show that the broker acted with criminal intent (that he or she was aware that the investment was a fraudulent one and sold it to the taxpayer by means of false statements)
Per Treas. Reg. 1.165-1(d)(3), the deduction must be taken in the year where there is no “reasonable prospect of recovery,” meaning that there is no substantial possibility that the taxpayer will have a claim settled on his or her favor. The taxpayer does not have to be an “incorrigible optimist” and the deduction will not be denied if the claim has merely “remote or nebulous” potential. “Reasonable certainty” is measured through a review of the facts and circumstances of the taxpayer’s particular case.
Taxpayers are obligated to provide the IRS with “credible evidence” of the value of the loss. For property theft, this can be done by means of a recent receipt or expert appraisal. If the loss was the result of investment fraud, the loss estimate may be made by the bankruptcy receiver for a bankrupt firm or someone with “scientific, technical, or other specialized knowledge” per Rule 702 of the Federal Rules of Evidence. The taxpayer’s subjective belief of the value of the item is generally insufficient.
Amount of deduction
If insurance or other third party reimbursement covers part of a theft loss, only the balance may be deducted. The deduction must also be reduced by the salvage value of a recovered item. Note that the taxpayer’s adjusted basis in any property that is recovered will be the taxpayer’s cost decreased by depreciation or increased by any amounts spent on repairs that restore the property to its pre-casualty condition.
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