Have you ever loaned money to someone who didn't pay you back? Did you know that if you can’t get your money back you could at least write the debt off for taxes? It’s called a “Nonbusiness Bad Debt” (NBD) and it is deductible as a short term capital loss in the year the debt becomes worthless. Or perhaps you loaned money to someone only to discover later you were swindled out of your money by a clever scam artist. That loss is called a theft loss (TL) and is deductible as an ordinary loss in the year you were certain you could not recover your money. Seems easy to take these deductions? Right? Wrong! There are IRS landmines waiting for you in Section 166 and Section 165 of the IRS Code. So if you have a TLs or NBDs and are not sure which year to claim or how much to claim, stay with us here on TaxView with Chris Moss CPA where you will learn how to save taxes by safely deducting a theft or bad debt loss.
So what qualifies as a NBD? IRS Code Section 166(d)(1) and Regulation 1.166-1(c) says that you have to have a debtor-creditor relationship with the person you gave the money to, that a genuine debt in fact existed and the debt was worthless in the year of deduction. Make sure your tax attorney includes sufficient evidence to prove that there was a genuine debt and include those facts in your tax return before you deduct the bad debt. Herrera vs IRS 2012, and affirmed on appeal to US Court of Appeals (5th Cir. 2013).
Theft loss or TL is covered under IRS Section 165(a)(3) and Regulations 1.165-1(d)(2)(i), (3), 1.165-8(a)(2). So if there is TL you can deduct the loss as an ordinary loss. Sometimes a TL could be also an NBD. This is “kind of” what happened in the US Tax Court case of Bunch vs IRS (August 2014). Mr. and Mrs. Bunch filed a 2006 income tax return claiming a bad debt of over $4 Million from Mortgage Co. Bunch then amended their tax return a few years later and changed the bad debt to a theft loss for the same amount claiming that the money had been stolen by an employee who worked at Mortgage Co. The IRS audited Bunch in 2009 disallowing both the bad debt deduction from the original return and the theft loss from the amended return. Bunch appealed to US Tax Court in Bunch vs IRS August 2014.
Judge Wherry says timing is everything when it comes to TL and NBD tax deductions. Indeed you can only deduct a TL or NBD if you can prove that no reimbursement is possible. The Court further noted that in fact Bunch did receive some recovery of the loss and therefore he could not deduct the loss for the amount and in the year the loss was deducted. Perhaps Bunch could have deducted a smaller loss that he did not recover in some future year, but unfortunately for Bunch that is not the tax strategy his tax preparer used. IRS Wins Bunch Loses.
Jeppsen v. IRS, 128 F.3d 1410 (10th Cir. 1997), affirming Tax Court Jeppsen v IRS (1995) further brings home how important it is to prove that no reimbursement is possible in the year you deduct the loss. Jeppsen deducted a theft loss of $194,000 on his 1987 tax return claiming a stockbroker misappropriated his money. However, Jeppsen also sued the broker over the next few years to try to recover the money and eventually won a damage award of $1.5 Million in 1995. The IRS audited Jeppsen about that time and disallowed Jeppsen’s 1987 loss because it was not certain back in 1987 whether or not Jeppsen would recover his stolen money. Jeppsen appealed to US Tax Court and lost. Jeppsen appealed again to the US Court of Appeals and also lost. IRS Wins Jeppsen Loses.
Halata vs IRS (2012) could happen to anyone who is greedy enough to believe what is too good to be true is true. Halata a Texas resident befriended Ojeda. Halata was told by Ojeda friend Montgomery that he could repay Halata over $2.5 million in return profits if she loaned him $180,000. Halata did in fact loan $180,000 to Montgomery. The money was never recovered. Halata never deducted the loss as she most likely did not know she could. Unfortunately for some other reason her 2007 tax return was audited by the IRS who sent Halata a large tax bill. Halata retained a tax attorney Polk to represent her. Polk claimed his client should be able to deduct the theft loss in 2009 and carry back the resulting net operating loss to 2007 this wiping out any taxes she might owe as a result of the audit. The IRS disagreed and Halata appealed to US Tax Court. Halata vs IRS (2012).
.Judge Morrison concluded that under Texas law there was in fact a theft but not until 2009. Unfortunately for Halata, the Court denied Halata the right to carry back this large loss to 2007 on procedural grounds in that her tax attorney did not raise this issue until after the trial. The Court did however grant Halata the right to take the loss in 2009 and then carry it forward to 2010 and beyond if necessary. This was a partial victory for Halata and partial victory for IRS. This case once again underscored the importance of timing when it comes to deducting TL or NBD.
In conclusion, if you all have a material TL or NBD, it is perhaps critical that you retain a tax attorney to prepare your tax return so that your strategy as to the timing of the loss can be properly documented and articulated to the Government in the tax return itself before filing. Do not file that tax return with a loss unless you can show that there is reasonable certainty that you could not obtain reimbursement for your loss in that specific year. Finally remember when it comes to TL and NBD, timing is everything, making the year of deduction more important than the deduction itself. Bullet proof your tax return TL and NBD strategy before you file. Your tax position will be safe and secure from IRS challenge for many years to come. Thank you for joining Chris Moss CPA on TaxView.
See you next time,
Chris Moss CPA