The Subprime Mess – Deducting Losses

June 22, 2007 | Roger McEowen

 

The problems associated with the subprime lending abuses have given rise to numerous issues.  One of those issues involves the deductibility of losses.  Two types of losses could be involved – theft losses or losses on worthless securities.

The rules for deductibility are different depending on the type of loss involved.  Theft losses are only deductible in the year of discovery rather than the year that the theft occurred, and the amount of the deduction is tied to the fair market value of the item immediately preceding the theft, limited by the taxpayer’s basis in the item.  In addition, any loss must be reduced by any insurance recovery.  Importantly, a theft loss is not treated as a capital loss.   

Losses on stocks and securities are also deductible, but under different rules.  A loss on a “worthless security” is deductible even if the taxpayer didn’t sell the security, but it’s only deductible in the year of total worthlessness.  But, what constitutes worthlessness?  An investment in a company that has gone bankrupt is not enough.  IRS says that if there is any chance the investment can recover, it’s not wholly worthless.  A broker’s note saying a stock ceased trading during the year would be helpful, as would a news article about the firm liquidating and evidence that it owes more to creditors and bondholders than the total of its assets.  That indicates that there won’t be any funds left for investors.  Also, IRS has been known to take the position that an investment is totally worthless if the taxpayer’s stock is still trading, but would bring less than the broker’s commission for selling it.  To write off a worthless stock, a taxpayer reports it on Schedule D as if it were sold for nothing at the end of the year.  That date also determines whether the taxpayer has a short-term or long-term loss.  Also, in the section of the Schedule D where the taxpayer is asked for the sale date and selling price, “worthless” should be entered.  The loss is the full cost of the investment.

There is potential overlap between theft losses and losses for worthless securities, and the current subprime problems may bring most of them out.  Recently, IRS issued a pronouncement dealing with the potential overlap.  Under the facts as presented to IRS, the taxpayers were lenders who loaned money to an established company that wrote subprime mortgage loans.  While the company had been a legitimate business, as its subprime losses mounted it provided false and fraudulent information to its investors to encourage them to continue to lend money to the company.  Eventually, several company insiders were convicted of or plead guilty to securities laws violations based on their misrepresentations to investors.  The investors did not get repaid, and the issue was whether their losses were theft losses or losses on worthless securities. 

IRS reasoned that the losses qualified as theft losses – they resulted from a taking of property that was illegal under state law and which was done with criminal intent.  IRS compared the situation to a 1971 Revenue Ruling (Rev. Rul. 71-381) in which a corporation provided fraudulent financial statements to obtain a loan, and the corporate president was convicted of violating state securities laws in issuing the statements.  The ruling allowed the lender to take a theft loss deduction for the loan amounts that were not repaid.  The key point is that a theft accomplished through a purported borrowing or offer to sell a security does not get converted to a worthless security loss, but can qualify as a theft loss.

Ultimately, IRS noted that the facts of a particular situation will determine the outcome.  At some point in time, loans to the lender will no longer represent bona fide debt.  So, it is a question of fact when a loan to a lender is no longer bona fide debt, but a theft.  It’s also a question of fact when an officer’s conduct concerning the money entrusted to the lender by the investors becomes an appropriation of those funds with the intent to deprive the investors of their property.   CCA Ltr. Rul. 200811016 (Jun. 22, 2007).