Theft Loss Tax Deduction

Most of the tax court cases I’ve posted about relate to people with either the common sense of a house gnat or  those simply trying to game the system. Today I stumbled upon a case where it’s the IRS that made the bone-headed move. Which surprised me, since the taxpayer was a lawyer and not a cheat (at least as far as the case goes). The case does, however, involve cheating.

The case starts with the simple premise: a theft loss tax deduction. For those wondering “Is theft tax deductible,” yes, it is. Code Section 165(c)(3) is one of the few places in the code that allows a personal loss deduction, “if such losses arise from fire, storm, shipwreck, or other casualty, or from theft” (emphasis added). This is, like everything else in our holy internal revenue code, limited by certain exceptions (the biggest one being if your insurance coughs up money for the theft), but the general rule is that theft loss is tax deductible.

Taxpayer in this case is a couple (yes, “Taxpayer” can be  plural in the accounting world) who likely spend every waking moment caring for their six children. When the sixth was on his (or her – gender is apparently irrelevant to this court) way, taxpayer decided their house needed to grow like their waistline, so they hired a contractor to blow out and expand a section of their house. Total payments would be $400,000, paid as certain milestones were met.

The contractor demolished said segment of the home without a problem. Taxpayer has to move in with the in-laws, 5.5 children in tow, while the house was rebuilt.

That’s when things started going wrong.  The contractor took Taxpayer and showed the current progress on the home, then explained he couldn’t continue without more money in advance. Taxpayer, with bundle of joy six now keeping them from sleeping through the night, and likely growing tired of the in-laws, were anxious to get back in their home. So they paid the money. They attempted to be careful, paying directly to subcontractors and part suppliers where possible, but quite a bit of it ended up in the contractor’s hands.


400k might have been a bargain

Unfortunately, the progress was a farce, a façade to get money without doing work. And then the contractor died.

Taxpayer, being a bold lawyer, actually attended the man’s wake to figure out how he’d get his house completed. Apparently so did several others of the contractor’s clients. Turns out Mr. Contractor had also been Mr. Drug-addict. The money was gone, and it hadn’t been invested hardware.

While Taxpayer could have instantly reported a theft loss tax deduction and called he a day, first they did everything they could to get their money back. They hit wall after wall (though, unfortunately, none of them could be erected in their home, or they wouldn’t have had a problem). They did end up recovering $10,000 from the contractor’s insurance, a pittance settlement from the insurance company, but more than they legally had to pay since the insurance had actually lapsed shortly after work on the home begun (with insurance contract likely rolled up and smoked).

The difference that taxpayer had lost, a total off $188,070, was reported as a theft loss tax deduction.

The IRS came back, probably two days before the statute of limitation ran out (because that’s what they always do), and said that the contractor stealing $188k of Taxpayer’s money didn’t constitute theft, and demanded taxpayer pay $52,944 of taxes with $10,585 of penalties.

Taxpayer, now as tired of getting screwed as a piece of wood in shop class, showed up in court, pulled out his state statute and underlined where home repair fraud is defined as theft. The judge likely muttered something under her (or his) breath about the IRS agent wasting her time, and threw the case out.

So is theft tax deductible? Yes, as long as its actually defined as theft by state law. And you don’t mind taking the IRS to court when they claim you did it wrong.


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Photo by Lee Cannon

NOTE: This, like everything else on this website, is not tax advice. If you want to know if you should take a theft loss tax deduction, hire an accountant. Or, apparently, a lawyer.