Code Section 165 basically establishes the general outline that governs the deductibility of losses. This statute permits a deduction for the following categories of losses as long as they the taxpayer is no reimbursed through insurance or otherwise:
1. Losses incurred in a trade or business (deductible without limitation)
2. Losses incurred in transactions entered into for profit, though not connected with a trade or business (deductible as capital losses); and
3. Losses of property not connected with a trade or business if such losses arise from fire, storm, shipwreck, or other casualty, or from an incident of theft (deductible as itemized deductions, subject to certain limitations)
Losses cannot be deducted unless attributable to a closed and completed transaction. This means that the actually property needs to transferred completely to recognize a loss. Mere declines in value or other unrealized losses cannot be deducted.
Normally, for the loss to qualify as a deduction, the property must be sold, abandoned, or scrapped. In some cases, an asset may be determined to be worthless and a taxpayer would need to prove its worthlessness to be able to take the deduction. The amount of the loss for tax purposes cannot exceed the taxpayer’s basis in the property.
James owns 100 shares of Johnson Corporation stock which he purchased on January 1, 2012, for $84 per share. On December 31, 2012, Johnson Corporation stock was selling at $52 per share. James cannot deduct the $32 per share decline in value on his 2012 tax return since it is an unrealized loss. James would have to sell the stock in 2012 in order to recognize a loss for tax purposes.