No Theft Loss or Bad Debt Deduction Allowed for Unwise Investment made by Taxpayers. (Parker Tax Publishing September 19, 2014)

Where a husband and wife attempted to claim a bad debt or theft loss for money invested in a fraudulent real estate development companythat had filed for bankruptcy, the court disallowed the loss as there was a chance the couple could recover, and did in fact recover, some of their investment. Bunch v Comm'r, T.C. Memo. 2014-177 (8/28/14).

Delbert Bunch was a broker, and his wife Ernestine Bunch a consultant. At the time the petition was filed, Delbert and Ernestine resided in Las Vegas, Nevada. In 2000, the couple discovered an opportunity in a newspaper advertisement to invest in U.S.A. Commercial Mortgage Co. (Mortgage Co.), which was headed by Joseph Milanowski. Mortgage Co. raised money from investors and made loans to real estate developers. Later that year, Delbert, Ernestine, and some of their family members loaned Mortgage Co. $10 million, of which the couple contributed $4,044,096 in exchange for a note. They were to be paid 20 percent interest per year, with the principal due one year after the final interest payment.

In 2001, several of Mortgage Co.'s loans went in to default and, in April of 2006, Mortgage Co. filed for bankruptcy under chapter 11. In November of 2006, Delbert and other unsecured nonpriority claimants filed a proof of claim for $11,385,662 against Mortgage Co. in order to prove their losses and apply for tax refunds. On their 2006 tax return, Delbert and Ernestine claimed a bad debt deduction of $4,044,096. In 2007, Delbert and Ernestine were informed that they could expect to recover around $500,000 of their loss, and sometime after 2009 they received at least one distribution from Mortgage Co. In 2009, the couple filed an amended 2006 tax return and changed the bad debt deduction to a theft loss deduction.. In 2011, the IRS determined a deficiency of $74,236 for Delbert and Ernestine's 2006 tax return.

OBSERVATION: In bankruptcy proceedings, creditors are paid out in order of priority. In general, secured creditors are paid first, with any remaining funds distributed evenly to unsecured creditors.

Under Code Sec. 165(a)(1), an individual taxpayer is entitled to a business or nonbusiness bad debt deduction if certain requirements are met Business bad debts offset ordinary income dollar for dollar, while a nonbusiness bad debt is treated as a capital loss. Additionally, a business bad debt may still be deducted even if it is only partially worthless, but a nonbusiness debt must be wholly worthless for a deduction. To be considered wholly worthless, there must be reasonable grounds for abandoning any hope of recovery.

Code Sec. 165(a) permits a deduction against ordinary income for any loss sustained during the tax year and not compensated for by insurance or otherwise. For individuals, the deduction is limited to, in relevant part, losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. Two elements must be proved to properly substantiate a theft loss deduction. First, the taxpayer must prove that the loss is attributable to a theft in the year for which the deduction is claimed. And second, because Code Sec. 165(a) allows the deduction for the year in which a loss is "sustained," the taxpayer must demonstrate that the loss was incurred in the year for which the deduction is claimed. Generally, a theft loss is treated as sustained during the tax year in which the taxpayer discovers it. However, under Reg. Sec. 1.165-1(d)(2), even after a theft loss is discovered, if a claim for reimbursement exists during the year of the loss and there is a reasonable prospect of at least some recovery, the theft loss deduction will be postponed until the prospect for recovery no longer exists.

The primary issues for the court were (1) whether Delbert and Ernestine could claim a bad debt deduction for the 2006 tax year, and if not, (2) whether they could claim a theft loss . Delbert and Ernestine attempted to establish their loss by filing a proof of claim in Mortgage Co.'s bankruptcy proceeding.

The court held that Delbert and Ernestine were not allowed a bad debt or theft loss deduction for 2006 because they had not proved there was no reasonable prospect of recovery as of the end of the 2006 tax year. The court found that, because the couple were merely investors in Mortgage Co., their debt was a nonbusiness debt. Subsequently, the court found that there was a reasonable prospect of recovery because the couple had secured a place in the order of distribution from the bankruptcy estate by filing their proof of claim. Thus, because they could not establish by the end of 2006 the amount of the loan they would not recover, Delbert and Ernestine could not deduct the debt as a wholly worthless nonbusiness bad debt in 2006. Similarly, the court denied the theft deduction because, Delbert and Ernestine could not substantiate the amount of alleged theft loss sustained in 2006. Additionally, the court noted that the couple did in fact recovery some amount, further undermining their claim for a deduction in 2006.

For a discussion on the tax treatment of bad debt deductions, see Parker Tax ¶ 98,401. For a discussion of the tax treatment of theft loss deductions, see Parker Tax ¶ 84,503. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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