A taxpayer will often prefer a theft loss deduction to a deduction for a worthless investment security. One advantage of theft loss treatment is that the loss is not a capital loss, unlike the worthless security loss. The timing of the loss may also be more advantageous for a theft loss, since the loss for a worthless security cannot be used until the security is entirely worthless (or the security is otherwise sold).
The subprime mess has given rise to an IRS pronouncement that deals with a potential overlap area between these two types of losses. The taxpayers here were lenders, who lent money to an established company that wrote sub-prime mortgage loans. While the company was at one time 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 insiders of the company were convicted of or plead guilty to securities laws violations based on their misrepresentations to their investors.
The investors did not get repaid on their investments. The issue was whether their losses had to be treated as worthless securities losses, or whether they could qualify for theft loss treatment.
In Chief Counsel Advise 200811016, the IRS held, surprisingly enough, that the losses qualified as theft losses. The Advisement noted that to qualify as a theft loss, a taxpayer needs only to prove that his loss resulted from a taking of property that is illegal under the law of the state where it occurred and that the taking was done with criminal intent. It also noted that in Rev.Rul. 71-381, a corporation provided fraudulent financial statements to obtain a loan, and the president of the corporation was convicted of violating state securities laws in issuing those statements. That ruling allowed the lender to take a theft loss deduction for the amounts that were lent and not repaid.
Thus, 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.