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07.10.18

The Tax Impact of Theft in a Real Estate Scam
Thomas Kosinski

No one ever wants to be the victim in a real estate scam, but as scams become more increasingly sophisticated, the risk is also growing rapidly. Though tax rules offer some relief, victims do not always benefit from a tax deduction for fraud losses. Some investors and owners recently learned that lesson the hard way.

Duped investors claim theft loss deductions

In 2006, taxpayers were given the opportunity to invest in a real estate development by financing the cost of the project for $500,000. The developers offered investors a purchase of 10-acre lots that the developers would repurchase for $625,000 a year later. The taxpayers would finance their investment through bank loans secured by the lot, and the developers would pay the interest on the loans while they were outstanding. The taxpayers accepted the offer and bought Lot 86.

Later, the investment was confirmed as a scam, and the developer never bought back the lots or developed the property. The lots could not be developed individually, and the taxpayers were left with large loans in their names, secured by property of little value. In 2008, taxpayers began filing lawsuits seeking recovery from the developers and the banks that financed the loans.

In 2011, the taxpayers filed amended tax returns for 2008, claiming deductions for theft losses related to the scam. They claimed a theft loss deduction of $361,347 for Lot 86 that would create a 2008 refund and a carry back of deductions to 2005 for another refund for that year. The IRS challenged the deductions and denied the refunds, so taxpayers took the case to district court.

Court sides with the IRS

The district court considered the refund claims related to Lot 86, but found many issues with the refunds. First, they concluded that 2008 was not the proper year to deduct the theft losses because the taxpayers had a reasonable prospect of recovery in that year due to filing pending lawsuits. The taxpayers claimed relief from an IRS Revenue Procedure that was released for victims of Ponzi schemes in the Bernie Madoff scandal. That procedure generally allows investors to claim theft-loss deductions in the year that criminal charges are brought for a fraud scheme.

Second, the court noted the relief applies only to a qualified loss from qualified investments. A qualified loss must result from certain fraudulent arrangements for which the lead figure was charged with fraud or embezzlement. The taxpayers did not have a loss from criminal charges. Also, amounts borrowed from the responsible group and invested in the fraudulent arrangement, to the extent they are not repaid at the time theft was discovered, are not qualified investments. Most of the investment was borrowed and not repaid, meaning that for the loss to be qualified, they would have to prove the bank was part of the fraud. So, they were not eligible for this relief.

The court ultimately concluded that the taxpayers could not claim the deductions in 2008 and had no refund claim for 2005. Not only were they not entitled to the refunds they sought, but once the lawsuits are settled, there is additional risk that the losses may become capital losses from their investment (which have annual loss limits) rather than a fully-deductible theft loss.

Duped owners claim theft loss deductions

In 2011, taxpayers were owners of a Florida rental home. They offered to rent a furnished 3,800 square foot home for a 12-month rental period.  The couple took extra steps to photograph rooms and furnishings in each room. When the tenants agreed to rent the home and purchase some of the furnishings that they wanted to keep, their rent and deposit checks bounced. The owners found all furnishings missing when they got access to the rooms and evicted the tenants.

The taxpayers claimed a $30,000 theft loss in 2012 when they were able to compute the amount of loss. The IRS disallowed the deduction, finding the owners did not have evidence of the loss. The tax court filed their decision in TC Summary Opinion 2017-79 allowing only a $9,200 loss.

Court adjusts the amount of theft losses

The Tax court considered the claim of a 2012 theft loss deduction. First, they concluded that 2012 was the proper year to deduct theft losses because the taxpayers could not recover losses. The taxpayers got help from the police who found a pickup truck with some of the furnishings. But, when the owners found that the tenants managed a regular scam on rental properties during 2012, they could not reduce their losses. Second, they concluded that owners did not keep evidence of asset values. Despite having pictures and lists of property, the owners computed losses based on catalogs and similar retail items offset by a discount for use. There was no age and condition to properly place a value, and the only full value allowed was for the furnishings offered for sale. As a result, the claim for theft loss deductions was limited to the value determined by the court, and the court allowed the IRS to assess an accuracy related penalty for the difference in value.

Never assume

When it comes to tax deductions, you need to prove all the requirements of the underlying law. Theft losses are even more difficult to claim because the timing and facts of each case are unique, which changes the tax impact of the losses. Your ORBA director can help you get the deductions you deserve and work with you to ensure you have support in case the IRS challenges the claim.

For more information about theft losses, contact Tom Kosinski at tkosinski@orba.com, or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.

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