As did many Los Angeles-area retirees, Pearl Anselmi bought bonds in American Continental Corp. thinking they were federally insured instruments. She found out later that the bond salesman lied about the federal insurance, among other things.
Her bonds are now worthless, and she fears that she will never see any recovery despite numerous class-action suits against the issuer, the Phoenix-based former parent of failed Lincoln Savings & Loan in Irvine.
But the Panorama City resident might be able to get back a portion of her $8,000 loss almost immediately--thanks to Uncle Sam and tax rules that might allow her and others to declare the losses as a "theft" on their 1989 income tax returns.
To Anselmi the issue is an important one. A retiree living on Social Security, she notes that every penny counts.
"If we could deduct the loss, we wouldn't have to pay any income tax this year," she said. "Every little bit helps when people get to be our age."
The issue revolves around how the Internal Revenue Service views investment losses and casualty or theft losses. Normally when an investor sells a stock or bond, it generates capital gains or losses. (A bond deemed worthless also can generate a capital loss even though no sale takes place.) Capital losses can be used to offset capital gains generally without limit, but only $3,000 of capital losses can be used in any given year to offset ordinary income from wages and salaries.
However, theft losses are in a different category. If the loss was considered a "theft," the only limitation is that the loss is deductible to the extent it exceeds 10% of annual adjusted gross income plus $100.
So in this case, Anselmi, who has an annual income of about $20,000 and no capital gains to offset, would be able to deduct $5,900 in 1989 if she calls her $8,000 bond loss a theft, compared to $3,000 if it were a capital loss.
However, in the long run, Anselmi would be able to deduct more by declaring this a capital loss, because capital losses do not have to exceed a certain percentage of income to be deductible. In other words, with a capital loss she could write off the entire $8,000 over time, compared to the one-time $5,900 theft deduction. And the time value of getting the $5,900 deduction up front is not substantial enough to offset the difference.
For others with larger losses in the bonds or relatively small incomes, that may not be the case.
A married couple who invested $100,000 in bonds and has an annual income of $50,000, for example, may be better off declaring the loss as a theft. That way they wipe out their taxable income for the year, said Jeff Joy, a tax attorney at Djang, O'Kain & Joy in Newport Beach. If they took it as a capital loss and had no capital gains, their deduction would be limited to $3,000 and their total tax would be around $6,568.
They could carry the capital loss forward, but it would take them 33 years to get the full benefit of the loss deductions.
But a theft loss can not only be carried forward, it can be carried back three years. So the taxpayer could potentially get their full deduction almost immediately by offsetting 1989 taxes and amending past years' returns until the full deduction is eaten up, Joy added. In this case, by putting the tax savings in the bank, the taxpayer may earn more in interest than they would have lost by the deduction's limitations.
Still, calling a loss on a bond--regardless of how it has been misrepresented--a theft, compared to a capital loss is merely what tax experts call an "arguable position." In other words, the IRS and the state Franchise Tax Board could challenge the deduction.
If they did, the taxpayer would have to prove his case in court or be subject to paying additional tax, interest and penalties. "It's not a slam dunk," said Mark Collins, partner at the accounting firm of Arthur Andersen & Co. "The IRS' view of theft is somebody breaking into your home and taking something. People would need to talk to their individual tax preparers to see if this makes sense."
Spokesmen for both the federal and state tax authorities agree. There is some case law that would allow taxpayers to take this position, but there have been numerous times when the IRS challenged the deduction and won in court.
How do you determine that the bonds are worthless? The best way is for a bankruptcy court to rule them so, but that's not always necessary, according to regulators and case law on the subject. Moreover, the taxpayer also does not need to prove that the issuer was convicted of fraud or theft to claim the deduction--although this also helps if confronted by the IRS or the Franchise Tax Board.
Decisions on whether the deductions are valid are made on a case-by-case basis, said Robert Giannangeli, public affairs officer for the IRS.
"I think you could probably take that position, but whether it would fly or not is another question," said Giannangeli. "The decision as to whether or not it is deductible more or less all depends on the facts of the particular case."
Giannangeli added that some might make the same claim about other bonds that have gone bad--such as those put out by Resorts International, Integrated Resources or Southmark Corp.--but it would probably be an unusual case when the IRS agrees.