Too Good to be True: Court Rejects Deductible Theft Loss for Real Estate Scam

No one wants to fall victim to a fraudulent real estate scam, but, as fraudsters become increasingly sophisticated, the risk is real. Though it’s a small comfort, victims should be able to claim a tax deduction for fraud losses, right? Not necessarily. Some investors recently learned that lesson the hard way.

Duped investors claim theft-loss deductions

In 2006, the taxpayers were given the opportunity to invest in a real estate project by financing the development. For $500,000, they could purchase a 10-acre lot, which the developers would buy back 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 agreed and bought Lot 86.

Later, they also purchased a smaller lot, Lot 135, through a partnership with their in-laws. The entire amount was financed, and they signed notes personally guaranteeing the loans.

Not surprisingly, the investments were too good to be true. The developer never bought back the lots or developed the property. The lots couldn’t be developed individually, so the taxpayers were left with large loans in their names, secured by property of little value. In 2008, they began joining lawsuits seeking recovery from various parties, including the developers and the banks that financed the loans.

In 2011, the taxpayers filed amended tax returns for 2008, claiming deductions for losses related to the scam. Specifically, they claimed a deduction of $361,347 for Lot 86 and $103,125 for their share of the partnership’s losses on Lot 135. These deductions would have reduced their tax liability for 2008 by $21,157, and they sought a refund of that amount. They also tried to carry back the deductions to their 2005 returns and sought another refund for that year.

The IRS disallowed the deductions and denied the refunds. The taxpayers turned to a federal district court for relief.

Court sides with the IRS

The district court considered only the refund claims related to Lot 86, finding it lacked jurisdiction over the claims related to the partnership losses on Lot 135. (See “Jurisdiction over partnership deductions.”)

Unfortunately, its ruling on the deductions for their direct investments in Lot 86 wasn’t good news for the taxpayers. The IRS concluded that 2008 wasn’t the proper year to deduct the theft losses because the taxpayers had a “reasonable prospect of recovery” in that year due to various pending lawsuits. To get around the need to prove they both discovered the loss and had no reasonable prospect of recovery in 2008, the taxpayers relied on an IRS Revenue Procedure that had been released in the wake of the Bernie Madoff Ponzi scheme scandal. That procedure generally allows an investor to take a theft-loss deduction in the year that criminal charges are brought for a fraud scheme.

As the court pointed out, though, the procedure applies only to a “qualified loss” from a “qualified investment.” A qualified loss results from certain fraudulent arrangements for which the lead figure was charged with fraud or embezzlement. The taxpayers provided no evidence of such criminal charges resulting from the conduct that caused their loss. Further, amounts borrowed from the responsible group and invested in the fraudulent arrangement, to the extent they weren’t repaid at the time the theft was discovered, aren’t qualified investments. Most of the taxpayers’ investment was borrowed and not repaid, meaning that, for the loss to be “qualified,” they would have to show that the bank they borrowed from was part of the fraud — but they didn’t address this requirement at all.

The court ultimately concluded that the taxpayers weren’t entitled to take the deductions in 2008 and therefore couldn’t carry them back to 2005. As a result, they weren’t entitled to the refunds they sought.

Never assume

When it comes to tax deductions, you’ll need to prove all the elements of the underlying law. Your CPA can help you get the deductions you deserve.

Jurisdiction over partnership deductions

The taxpayers in Hamilton v. U.S. sought a tax refund based on their share of the partnership’s theft-loss deduction related to Lot 135. (See main article.) But, under tax law, district courts can’t hear taxpayer actions for refunds attributable to “partnership items” — including a partner’s share of the partnership’s deductible losses — unless an exception applies.

Under one such exception, a partner may be allowed to seek a refund if the IRS denies the partner’s administrative adjustment request (AAR) to amend the reporting of partnership items on a previous tax return.

In Hamilton, the taxpayers admitted they hadn’t filed an AAR but argued that an amended return filed by the partnership was the functional equivalent of an AAR. The court disagreed, finding that an AAR filed by a partnership doesn’t satisfy this exception — the IRS must have rejected an AAR filed by a partner. Thus, even if the taxpayers’ partnership had filed an AAR, it wouldn’t have given rise to jurisdiction in this action.

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