Update on Theft Losses: 'McNely v. Commissioner'

Although the Internal Revenue Code (Code) has long allowed a deduction for losses attributable to theft and casualty, claims for the deduction of such losses are often challenged and sometimes disallowed. Even where it is undisputed that a theft occurred, and the amount of the loss is also clear, a deduction for theft under Code §165 may be disallowed if the loss was not claimed in the appropriate year. McNely v. Commissioner (TC Memo 2019-39), a recent Tax Court memorandum decision discussed below, sustained an IRS determination that no theft loss was allowable, and provides some useful lessons as to traps for the unwary in this context.

Facts

Donnovan McNely (McNely) and Jeffrey McKay (McKay) incorporated M & M Properties (M & M) in 2008 and each owned 50% of the stock of M & M, which was an S corporation for federal tax purposes. M & M was initially involved in the real estate business in northern California exclusively, but then began to purchase distressed real estate properties in southern California, including six such properties in 2010.

The sales of southern California properties to M & M turned out to be part of a fraudulent scheme in which bank debt secured by each property that was supposed to be paid off in connection with each sale was not in fact paid, such that M & M lost its ownership of the property and entire investment therein when the bank holding the note foreclosed. Bona fide title insurance companies were involved in some transactions pursuant to the scheme, but other transactions involved fake title insurance companies created under the fraud scheme.