When casualty or theft strikes, the law allows businesses and individuals to claim a tax deduction for the resulting loss. For individuals, you can generally deduct the amount of your unreimbursed loss to the extent the loss exceeds 10 percent of your adjusted gross income for the year. Before applying the 10 percent limit, you must subtract $100 for each casualty or theft occurrence.

It is common for the IRS to challenge such deductions, particularly for individuals, on the grounds a theft or casualty has not occurred -- or that it was claimed in the wrong year. This was illustrated in a recent Tax Court case.

Facts of the Case

The taxpayers claimed a theft loss but it wasn't an ordinary theft. Mr. and Mrs. Uris entered a contract with Onyks Construction and Remodeling (Onyks) for the expansion of their home. The contract stated they would pay $400,000 to destroy part of the house and construct an addition. Onyks was owned and operated by Dariusz Potok.

The taxpayers were to make installment payments based on completion milestones. Onyks was to construct interior portions of the house, and provide necessary wiring, plumbing, air conditioning and heating. Construction began in November 2005, after signing the contract. Because the house was not habitable during construction, the taxpayers stayed elsewhere.

Soon Onyks began demanding payments for the purchase of materials, before milestone completion. The contractor threatened delays if payments were not received. The taxpayers complied with the requests but became concerned with the progress, and began making payments directly to subcontractors. With the project behind schedule, Potok suddenly died at age 30. The taxpayers then learned the subcontractors had not been paid. They also found Onyks failed to adequately protect the home from the elements, resulting in damage to portions of the interior, which were not under construction.

Before signing the contract, Onyks provided the taxpayers proof of insurance. In August 2006, two weeks after Onyks died, the taxpayers filed an insurance claim "for negligent construction, property damage and failure to perform."

In October 2006, the taxpayers filed a lawsuit in the Circuit Court of Cook County, Illinois against Onyks. It wasn't until March 2007 that the insurance carrier supplied a copy of the contract after the taxpayers secured a court order demanding it.

The policy stated it did not apply to "Knowing Violations of Rights of Another," which are "caused by or at the direction of the insured with the knowledge that the act would violate the rights of another."

After determining they could not recover under the policy for Potok's improper use of the funds, their lawsuit proceeded on grounds that Onyks negligently damaged their property during construction. During litigation, it was revealed that the insurance policy had lapsed for nonpayment of premiums shortly after the construction contract was signed. The taxpayers later settled with the insurance company for $10,000.

Though the taxpayers knew Onyks and Potok were in financial difficulty, they hoped to recover something from the estate. However, the taxpayers were unable to recover any funds from Potok's family or estate.

Apart from the initial $400,000 paid on the contract, after Potok's death, the taxpayers spent significant sums to repair the damage and complete the construction. They then claimed a $188,000 theft loss deduction on their 2007 income tax return. This was as a result of the money paid to Potok, which they determined was improperly used for purposes unrelated to their construction project. The claim did not include damages resulting from the alleged negligence.

The IRS disallowed the loss, stating Potok's actions were not theft as defined under Illinois State Law, and that the deduction should have been claimed for 2006, not 2007.

What Constitutes Theft?

The Tax Court noted "theft is intended to incorporate any criminal taking of another's property, including the crime of false pretenses. The factual existence of the theft must be established by reference to the law of the jurisdiction where the loss occurred. Although a criminal conviction in a state court may conclusively establish the existence of a theft, the deduction does not depend upon whether the thief is convicted, prosecuted, or even whether the taxpayer chooses to move against him. Moreover, the taxpayer must prove a theft occurred under the relevant state statute only by a preponderance of the evidence."

In addition, the Court noted the contract fell under the Illinois statute and Potok knowingly used deception and misrepresentations to induce the taxpayers to enter into it. The contract also required Onyks to notify the taxpayers of changes regarding its insurance. Moreover, Potok falsely reported the work completed in order to get early payments. The Court held the taxpayers were victims of a theft entitled to the theft loss deduction.

Timing

Having proven the existence of theft, the taxpayers had to show their deduction was taken in the proper year. The appropriate year for a loss deduction is the year it is sustained. However, if there is a reasonable prospect of recovery -- meaning the taxpayer has a bona fide claim for recoupment and a strong possibility the claim will be decided in the taxpayer's favor -- the taxpayer cannot claim a deduction until there is reasonable certainty whether a reimbursement will or will not be received.

Filing a lawsuit to recoup the loss is one of the relevant factors to consider. The taxpayers argued they had a reasonable prospect of recovery in 2006, when they believed they could recoup from Potok's estate, Onyks, or the insurance company. It wasn't until 2007 when they secured the insurance policy that they determined there was no chance of recovery under the policy.

The Court also noted the dissolution of Onyks occurred in 2007. The Court found the proper year for the deduction was 2007. (James M. Urtis and Gaetana R. Urtis, T.C. Memo. 2013-66)

Lessons to Be Learned

The taxpayers in this case handled the situation correctly. They had their facts in order, and they sought recovery from the various parties before claiming a deduction.

It's not enough to show a contractor didn't complete the job to your satisfaction. For a claim of theft loss, the contractor must commit fraud of theft, and this must be determined by the state laws where the transaction took place.

The second test -- taking the deduction in the proper year -- is equally as important. Take it too late and you may lose the chance to amend your return. A loss here is likely to be large, and may result in an inquiry from the IRS. The tax agency knows many taxpayers don't understand the rules with respect to casualty losses. The existence, timing and amount of a loss are critical factors. For tax and non-tax reasons, you must keep a diary of your actions -- such as when payments were made and details of contacts with the contractor. In this case, it helped show the contractor made misrepresentations.

There's a non-tax lesson here too. Keep a close watch on contractors. Make frequent visits to the job. Contact the subcontractors and ask if they've been paid. Find out if the insurance certificate (and the contractor's license and bond, if any) is current, and know what it covers. Seek professional advice regarding the tax deduction, as soon as possible after you discover the loss. Wait too long and you may lose the chance to take action that could help your case.

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