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Make the IRS Share Your Pain FORBES Interviews Mitchell S. Fuerst, Esq.

Investment Guide

Make the IRS Share Your Pain

Fire? Theft? Bum investments? Yes, you can deduct some losses. But the rules are tricky, and not all losses get equal treatment.

Between 1992 and 2000 Clearwater, Fla. tech entrepreneur Michael Kaplan and wife Anita poured $5.9 million into investments managed by Reed Slatkin, a founder of Internet provider EarthLink. They never withdrew a penny, using other funds to pay taxes on the interest, dividends and gains Slatkin reported to them. By 2000 their balance stood at $11.2 million--or so Slatkin said.

Slatkin is now doing 14 years in the federal pen for orchestrating a $600 million Ponzi scheme, and the Kaplans are doing time in tax purgatory. The Internal Revenue Service insists they and other victims can't deduct their losses until they know precisely how much of their investment they'll get back. But that will take years more, says bankruptcy trustee R. Todd Neilson, who is trying to recover $188 million in net "profits" paid to 470 Slatkin investors who cashed out early and redistribute them to 340 losers.

Mitchell Fuerst, the Kaplans' lawyer, argues the IRS should allow the Kaplans and others to write off their expected losses first and report any recovery later as income. "Delaying the embezzlement loss is unfair," he says. After Fuerst sued, the IRS coughed up $958,000 in taxes the Kaplans paid in 1997, 1998, and 1999 on phantom Slatkin profits they'll never receive. (All Neilson is trying to recover is their original investment.) But the Kaplans can't claim refunds for taxes paid on bogus profits from earlier years since taxpayers have only three years to amend their returns. Their only options for the early years involve a writeoff of some sort against later income--either a capital loss or a casualty (theft) loss. As you will see below, neither option is as good as undoing the old tax returns.

When you've got gains, Uncle Sam is an eager partner. And when you've got losses? Sometimes you can force him to share your pain and sometimes not. Here's a guide.

Disasters and Thefts
Line 19 of Schedule A for Itemized Deductions sounds simple: "Casualty or theft losses"--until you see the 39-line Form 4684 needed to claim this break. The first $100 of any loss isn't deductible, and each loss is further reduced by insurance proceeds you get and the salvage value of your property and is then limited to your basis in the property. (If you spent $200,000 on a beach house, that's all the loss you can claim, even if it was worth $1 million before the hurricane wrecked it.) Finally, all your casualty and theft losses are tallied up and are deductible only to the extent that they exceed 10% of your adjusted gross income.

You can't save up losses to meet the 10% test; usually you must claim a casualty loss in the year it occurs. A theft loss must be claimed in the year you discover it or, if you have a reasonable prospect of recovery, when you know the size of your loss--the issue in the Slatkin case. While the law discourages the deduction of small losses, it's generous for big ones. A loss that exceeds your income creates a "net operating loss," which--just like the net operating loss from a business--can be carried back to claim refunds for the past 2 to 5 years and carried forward for up to 20 years.

What's a casualty loss?

Damage due to an unforeseeable sudden event--fire, flood, earthquake, even vandalism. Routine wear and tear doesn't qualify in itself, but can cause a casualty. Last year a U.S. Tax Court judge allowed a woman to deduct $27,920 in water damage to her house and possessions caused by a deteriorated washing machine hose. Damage must also be permanent. In 2000 another judge denied a $751,427 casualty loss claimed by a couple who had agreed to pay $2.8 million for a Brentwood Park , L.A. house adjacent to O. J. Simpson's--ten days before the murder of Simpson's ex-wife, Nicole. The judge concluded that the media hordes and "looky loos" were a nuisance but caused only minor physical damage and a temporary decline in the house's value.

As a general rule you can claim a theft loss only if someone could be prosecuted under state law for stealing from you. If your broker gets sticky fingers, that's theft. But the Treasury recently warned taxpayers that--rumors to the contrary--they can't deduct a drop in the value of publicly traded stock as theft just because fraud caused the company to collapse.

Individual Retirement Accounts
John D. Stoller, an Encino, Calif. CPA, delivered some bad news recently to a couple who had lost $780,000 in IRA funds to a crooked trustee: They couldn't deduct one cent of that loss. "They were not happy campers," Stoller says. Remember the rule about not claiming a theft or casualty loss that's greater than your basis? Since the money in a traditional deductible IRA or a 401(k) has never been taxed as income, the taxpayer has no basis for the purpose of claiming either investment or theft losses. Unfair? Not really. Say someone hires you to do work and skips town owing you $50,000. That's theft. But the only break you get is that you aren't taxed on the $50,000 of never-collected income.

Losses in Roth IRAs, which are funded with previously taxed earnings, can be deducted--sort of. First you must liquidate all of your Roth accounts, and then, assuming what's left is less than you originally put in, you can claim the decline as a miscellaneous itemized deduction. But such deductions are only allowed to the extent they exceed 2% of your adjusted gross income and are denied completely in the alternative minimum tax calculation. Worse, if the money in the Roth came from the conversion of a traditional IRA and hasn't been in the Roth for a full five years, and if you're under 591/2, you'll owe a 10% early distribution penalty on the entire liquidated balance, points out Chicago tax lawyer Kaye Thomas, author of the Fairmark Guide to the Roth IRA.

Portfolios
You could write a book on all the weird rules that relate to capital gains and losses. Partly because there are different maximum rates on gains (short-term, 35%; long-term, 15%; collectibles, 28%; some real estate gains, 25%), there are messy rules on how to handle losses. Your losses in each category are first netted against your gains in that group and then against gains in the other groups. If you don't have enough of any gains to sop up your capital losses, $3,000 in capital losses a year can be used to offset ordinary income (say, from your salary). That stingy $3,000 is why a big Enron loser would claim a theft loss, if he could. Mutual fund holders get a bum deal. Funds must pass on their net taxable gains at the end of each year to all current shareholders (even to a holder who may himself be sitting on a loss in the fund). But they can't pass on losses. To realize a loss in a fund, you must sell your stake.

Annuities and Insurance
Insurance salesmen sometimes use this pitch: If you ditch that old dog of a variable annuity and buy a new one from me, you can deduct your loss on the old annuity above the line--that is before you calculate your AGI. Can you? There appears to be "substantial authority" for it, meaning if your accountant or lawyer recommends this in writing, you shouldn't get penalized, says CPA Robert S. Keebler of Virchow, Krause & Co. in Green Bay, Wis. But a safer approach, he says, is to claim the loss as a miscellaneous itemized deduction. Losses in whole and variable life insurance policies aren't deductible. And Keebler advises against a ploy he's heard pitched: exchange your losing life policy for an annuity and then claim a loss on ditching the annuity a year later.

Passive Activities
Since Congress cracked down on partnership tax shelters in the 1980s, losses from "passive activities"--business activities in which you don't materially participate--have been subject to their own complicated and restrictive rules. Generally, passive losses can be deducted only to the extent you have passive income from similar activities, and losses that can't be used are carried forward until you sell the investment. At that point they are first used to offset any gain from the sale and then, if you still have losses, can be claimed against your other income.

If you own rental real estate, and if your income isn't too high, there's a small exception: You can claim up to $25,000 a year in losses from a rental you manage from afar (say by approving new tenants and big expenditures), as long as your AGI (with some weird modifications) isn't more than $100,000. After that, your allowed loss is phased out and disappears at $150,000.

Bad Loans
If you've made a personal loan that can't be repaid, you can deduct it as a short-term capital loss on Schedule D in the year you conclude you'll never collect. But watch out. The IRS is suspicious that such bad loans are really disguised gifts, particularly if they were made to a relative or friend. So you'll need to document that this was an enforceable loan and you tried to collect. Cupertino, Calif. tax adviser Claudia Hill says she was about to challenge a client who wanted to claim a $120,000 loss this year for a bad loan to his son--until he showed her the claim he had filed against his own flesh and blood in bankruptcy court. (He'd lent his now-insolvent son the cash to start a business.) Funds you lend your kids for living expenses are never deductible.

Your House
Yes, your primary residence can go down in value as well as up. And no, you can't claim a deduction if you do sell it at a loss.

Taxpayers sometimes think they can convert an underwater home to a rental property and sell a few years later at a loss, notes Hill. No dice. Your basis in the new rental property, for the purpose of claiming a loss, is its market value at the time you converted the house to commercial use, less any depreciation you later claim. The basis for the purpose of a gain, however, is the amount you paid for it, minus depreciation. Thus if you have to move and believe the market will rebound, it might make sense to convert your primary home to a rental until its value does come back.

Shares Given Away
You can't pass on loss carryforwards to heirs other than a spouse. But if you have stock that is deep underwater and will probably rebound, the smart move is to give it to the kids while you're alive rather than to leave it as part of your estate. Say you bought the shares for $100,000 and they're now worth $20,000. If your kids inherit, their basis is $20,000 and they'll owe capital gains tax on any value above $20,000 when they sell. But if you give the shares to your kids, they take on your $100,000 basis in them--for the purposes of gains, although not for losses. They can't sell the stock for $20,000 and claim an $80,000 loss. But if the shares recover and they sell for $100,000 or less, they'll have no taxable gain.

Kiddies
Children under 14 with investment income of more than $1,600 are taxed at their parents' higher tax rate, and their income can in some cases be reported on their parents' return. But this "kiddie tax" only works against you--if your kids have capital losses, they must file separately and you can't use their losses. Still, like other taxpayers, kids can shelter up to $3,000 in ordinary income a year by using up their capital loss carryforward. So if they've built up capital losses, you may want to put taxable bonds, real estate investment trusts or other highly taxed ordinary income investments in their accounts.

Hobbies
You can use losses from an avocation to offset your main income, but only if you can convince the IRS (or a judge) that you intended to make a profit. Otherwise, you are subject to the hobby-loss rule: Your expenses for the venture are only deductible to the extent you have revenues from it and, moreover, must be claimed as miscellaneous itemized deductions (which are allowed only to the extent they exceed 2% of your AGI and disallowed in the AMT). You could end up paying taxes on profits when you really had losses. One way to avoid falling into the hobby hole is to show a profit in at least three years out of five; if you do, you're presumed to be running a business, and it's up to the IRS to prove it's a hobby. Don't cook your books, but take steps to limit expenses in the "profit" years--cut back on business travel, postpone buying equipment, use your home office for personal stuff, too, so it won't be deductible.

Even if you never show a profit, you can claim your losses if you can show you had good reason to believe you might make money--a chance for a substantial profit in a speculative venture is enough--and adjusted your strategy or quit the business when it didn't pan out. But don't expect IRS auditors to like these losses, particularly if the venture smacks of a luxury activity.

Example: The IRS asserted $216,000 in extra taxes and penalties against a New York gynecological oncologist who lost money on a racing boat he intended to enter in the 's Cup. Last year a Tax Court judge ruled for the doc, concluding he had reason to believe he might make a profit, had made money buying and selling other boats and was done in by factors beyond his control. But this year another judge denied a Washington, D.C.-area plastic surgeon $4.1 million in business loss deductions for a 108-foot yacht, supposedly built for Henry Ford II, that the surgeon bought and restored. The judge found this doctor had no experience in yachts and hadn't made a "good faith, reasonable investigation" into the deal's profit potential.

Gambling
Gambling losses can be deducted to the extent you have gambling winnings--but not against any other income. (Remember, casinos and tracks must report large winnings to the IRS.) This rule sounds fair, but is something of a sucker loss. First, unless you're a professional gambler, you must claim gambling losses as a special type of miscellaneous itemized deduction; they're not subject to the same 2% of AGI haircut as other miscellaneous itemized deductions are, but they still aren't allowed in the AMT. Second, you need to have substantiation of your losses--either a diary recording your wagers, wins and losses or some credible paper, such as casino credit card receipts or frequent gambler card records.

Janet Novack, FORBES, 06.07.04