In the case of Hamilton v. United States, USDC Northern District of Indiana, Case No. 1:15-cv-00303 a couple was attempting to invoke Revenue Procedure 2009-20 to claim a theft loss related to a failed investment scheme.

The Hamiltons had invested in a program where their credit would be used, along with the credit of others, to finance a development.  As the Court described the arrangement:

In 2006, plaintiffs Robert and Joan Hamilton were approached with an investment opportunity in a real estate development project in North Carolina known as the Grandfather Vista Development. The investment was portrayed as the means by which the developers were financing the development. For $500,000, investors could purchase a 10-acre lot within the development site from the developers. They would also simultaneously execute a buy-back agreement effective one year after the date of purchase, by which the developers would repurchase the lot at a price of $625,000. The developers personally guaranteed the buy-back agreements, and apparently represented to buyers that they had over $100 million in net worth, meaning they portrayed the investment as nearly risk-free. In addition, the buyers would not need to put substantial amounts of cash into the investment; instead, they would finance the investment through bank loans secured by the lots they were purchasing. The developers also agreed to pay the interest on those loans over the one-year period they would be outstanding. Thus, for a small down payment, the investors believed they would receive large, guaranteed returns after one year. As the Hamiltons explain it, they “understood that in exchange for using [their] credit to procure loans from pre-arranged banks, [they] would be repaid within a year with a significant return.”

The Hamiltons took the bait, although some might have worried that this deal sounded too good to be true.  For instance, it might raise some questions why the developers, if they were truly as financially sound as they asserted, would be forced to use such a high cost program to provide only short-term financing.  The Court pointed this out in a footnote, stating “[i]t is unclear how the developers explained their willingness to pay a twenty-five percent interest rate if they had such substantial assets to offer as security.”

If your “this is too good to be true” alarm went off when reading that paragraph, your concern was well founded—the buy-back never happened nor were the lots ever developed.  As the Court notes:

The developer never actually developed the property either, so the lots, which could not be developed individually, ended up being worth very little. Thus, the Hamiltons were left with large loans in their names, secured by property of little value. They state that they discovered the fraudulent nature of the project in 2008. In that same year, the state took action to shut down the Grandfather Vista development and another development in which some of the same developers were involved.

The Hamiltons joined in suits related to these transactions to attempt to be made whole, beginning in 2008.  These lawsuits continued for several years, but eventually the Hamiltons were forced to declare bankruptcy to release their liabilities on these loans.

In 2011 the Hamiltons met with an accountant to determine what to do about these losses.  The accountant suggested they file amended income tax returns for 2008 to claim a theft loss from the transaction.  That revision to their 2008 return generated a net operating loss which they then carried to 2005.  However, the IRS denied their claims for refund, leading to the couple filing suit against the government.

A theft loss is deductible under IRC §165.  Reg. §1.165-8(a)(2), interpreting §165(e), provides:

(2) A loss arising from theft shall be treated under section 165(a) as sustained during the taxable year in which the taxpayer discovers the loss. See section 165(e). Thus, a theft loss is not deductible under section 165(a) for the taxable year in which the theft actually occurs unless that is also the year in which the taxpayer discovers the loss. However, if in the year of discovery there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, see paragraph (d) of Section 1.165-1.

Reg. §1.165-1(d)(3) provides:

However, if in the year of discovery there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained, for purposes of section 165, until the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received.

As the taxpayers had claimed that 2008 was the year the loss was deductible, the fact that they filed suit against the other party and continued to participate in that litigation for several years after 2008 was a problem.  The taxpayers, recognizing that showing that in 2008 there was no reasonable prospect of recovery would be problematical, argued that their situation was one covered by Revenue Procedure 2009-20.

Revenue Procedure 2009-20 was issued shortly after the Madoff Securities fraud was uncovered.  That procedure provided, for losses that met the requirements of the Revenue Procedure, the potential for recovery would not totally bar a deduction for a loss in the year criminal charges are brought against the promoters.  For losses covered by that Revenue Procedure, 75% of the loss is allowed in the year of the criminal charges if the taxpayer is seeking recovery from third parties or 95% of the loss if the taxpayer is not seeking recovery from third parties.

To be able to claim a loss under Revenue Procedure 2009-20 certain requirements must be met. First, the “lead figure” in the scheme must be criminally charged with the commission of fraud or embezzlement or was the subject of a federal or state criminal complaint alleging such a crime.  In the case of the Hamiltons, they presented no evidence that the lead figures in this scheme were charged with any crime regarding this program. 

The Hamiltons pointed out that Revenue Procedure 2011-58 allowed for civil complaints to also be used to qualify for relief under Revenue Procedure 2009-20.  While it is true that Revenue Procedure 2011-58 did modify Revenue Procedure 2011-58 to allow civil proceedings to also count as the trigger for the special deduction rules, it only did so in the very limited case where the death of the lead figure precluded a criminal prosecution.  In this case the lead figures were very much alive, so civil proceedings did not trigger the special deduction.

Yet another requirement of Revenue Procedure 2009-20 is that the deduction is precluded for any amounts borrowed from the responsible group and not yet repaid.  The Hamiltons had borrowed a large portion of the funds which had not yet been repaid, so they had to show that the bank was not part of the “responsible group” in this, something the taxpayers had not shown.

Since they could establish neither that there was no reasonable prospect of recovery nor that they qualified for Revenue Procedure 2009-20 relief, no deduction was allowed for 2008 or for the carryback of the loss to 2005.