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Lessons from the Tax Court: Salvage tax loss from scams

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in Small Business Tax,Small Business Tax Deduction Strategies

Have you lost money in an illegal investment scheme? Even if you haven’t been fleeced by Bernie Madoff or some other high-profile shark, it can still hurt you plenty in the wallet.  

Strategy: When it’s appropriate, claim an investment theft loss for your troubles. For tax purposes, most investment losses are treated as capital losses, which are subject to strict limitations on deductibility. In contrast, losses that can be properly characterized as investment theft losses are treated as ordinary losses, which can be deducted without limitation. (Unlike a “regular” theft loss, the allowable deduction for an investment theft loss is not reduced by 10% of your adjusted gross income.)

On the other hand, as evidenced by a new case, you won’t necessarily qualify for an investment theft write-off just because you have an investment that went sour.

New case: A taxpayer invested in unsecured interest-bearing notes sold by American Business Financial Services (ABFS). After receiving monthly interest checks, he invested more money. Subsequently, ABFS began defaulting on its obligations. The taxpayer claimed an investment theft loss based on his unrecovered funds, but the IRS challenged the deduction.

The district court in Ohio examined the definition of theft offenses under state law. In this case, the taxpayer must prove that the accused engaged in a deceptive act intended to deprive the owner of possession of property or services. Furthermore, the accused’s misrepresentation must have caused the property to be transferred.

The court noted there was no evidence that ABFS possessed a criminal intent to deprive the taxpayer of his money without planning to pay it back. The monthly interest payments indicated otherwise. In addition, there was no evidence to support the taxpayer’s claim that he relied on fraudulent misrepresentations by ABFS. Case closed in favor of the IRS. (Labus, DC-No. Ohio, No. 5:11-cv-01856-JRA, 9/27/12)

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