Theft loss deduction
With the increased occurrence of individuals falling victim to embezzlement schemes, the Franchise Tax Board (FTB) offers this reminder on how to properly deduct these losses on their income tax returns.
A taxpayer's ability to take a theft loss deduction is governed by Internal Revenue Code (IRC) Section 165 (a) and (e). California Revenue and Taxation Code (CR&TC) Section 17201 conforms to IRC Section 165.
IRC Section 165(a) allows a taxpayer to deduct any loss sustained during the taxable year that is not compensated for by insurance or otherwise. A loss is treated as sustained during the taxable year in which the taxpayer discovers the loss. However, if a taxpayer files a claim for reimbursement, then the amount and timing of the deduction require further analysis on a case-by-case basis. When a taxpayer has a claim for reimbursement, they must also determine if there is a reasonable prospect of recovery for that claim. Taxpayers cannot deduct any amount for losses where a reasonable prospect of recovery exits. They must wait until it can be established with reasonable certainty whether such reimbursement will be received. More examples of these scenarios can be found in the Treasury Regulations under Section 1.165-1.
FTB is seeing an increase in tax returns where taxpayers are deducting theft losses even though there is a reasonable prospect of recovering at least some of their losses at the end of the taxable year. If there exists, in the year the loss was discovered, a claim for reimbursement with a reasonable prospect of recovering the loss, then FTB will treat the loss, for purpose of Regulation 1.165-1(d)(3) and 1.165-8(a)(2), as not sustained. We will treat the loss as sustained only in the taxable year in which it becomes reasonably certain which amounts will not be recovered.