8710 / What is a theft loss?

Editor’s Note: Under the 2017 tax reform legislation, individuals are no longer entitled to deduct casualty and theft loss expenses as itemized deductions (when those losses are not related to property used in a trade or business). An exception exists for losses that occur in federally declared disaster areas.¹ However, if a taxpayer has personal casualty gains, the new rules do not apply (even if the loss does not occur in a federal disaster area) so long as the losses do not exceed the gains. This essentially means that casualty losses will continue to offset casualty gains.² This provision applies for tax years beginning after December 31, 2017 and before January 1, 2026. The rules outlined below generally apply for tax years beginning before 2018, and for losses that are sustained in a disaster area.

A theft loss is a loss sustained as a result of (among other things) larceny, embezzlement or robbery.³ The taking of property must be illegal under the law of the state where it occurred and it must have been done with criminal intent. A conviction does not need to occur, however, to show a theft loss.⁴

The definition of “theft” is given a broad meaning and, therefore, a theft loss deduction may often be allowed in situations that do not involve the straightforward theft of property. For example, the IRS has allowed a theft loss deduction when a publicly-traded company misrepresented its financial condition in a business transaction in which the company traded its common stock in a tax-free reorganization and that stock subsequently became worthless. The IRS analogized the situation to “larceny by false pretenses” in that the company’s officers knew that their representations were false.⁵

In Revenue Ruling 66-355, the IRS held that a theft occurred when a taxpayer’s employee pledged shares of the taxpayer-employer’s stock as collateral to secure a personal loan. When the bank later sold the stock, the taxpayer-employer was able to treat the property as stolen, and the proceeds obtained in the employer’s settlement of the lawsuit against that employee were considered proceeds obtained as a result of an involuntary conversion (see Q 8711).⁶

The decline in the market value of stock is not deductible as a theft loss where the stock is acquired on the open market if the decline is caused by accounting fraud or other illegal misconduct by the officers or directors of the corporation that issued the stock. However, the loss sustained when stock is sold or exchanged, or becomes completely worthless, is deductible as a capital loss reportable on Schedule D of Form 1040.⁷