bad debt or theft?

Normally, lost deposits with contractors who fail to perform are treated as nonbusiness bad debts when it is determined that the debt is totally worthless. I.e., there is no way to recover the deposit. This is taken as a short-term capital loss on Schedule D.

A theft loss becomes an itemized deduction subject to the casualty rules (-$100, excess over 10% AGI) in the year you discover the theft.

Whether or not what you describe was a theft depends upon intent by the contractor. The fact that the contractor was in bankruptcy procedures does not by itself show intent to defraud.

Whether we have a bad debt or a theft, from the facts you present, it appears that no tax benefit would have been available in 2008 as recognition that there may have been a theft did not occur until 2009 or the ability to recover any part of the debt became zero in 2009.

Exactly when was the bankruptcy filed in relation to when the payment was made? That could be critical in determining both practical and tax issues.

If bankruptcy was filed shortly after the payment, it could well be considered fraud if the contractor knew he was going to file bankruptcy but didn't disclose it. That would make it a theft loss.

If it wasn't theft, but the bankruptcy was still filed in 2008, I'd think the bad debt loss could be deducted in that year.

Was it fraud? Did the contractor plan to take money with no intention of doing the work? Did your client file a police report claiming fraud?

It seems the contractor will deny having evil motives. Just bad luck:-(

Was the up-front expense for the contractor deducted as a rental expense in 2008?

In 2008 the theft loss is -$100, excess over 10% AGI, but in 2009 the loss is -$500, excess over 10% AGI.

The 2008 return has not been filed yet; the client does not want to file without claiming the loss.

To try and answer some of the other posts, the contractor had already filed bankruptcy when he accepted the money (I believe in August) and never did any work. The client did hire an attorney this year in an attempt to recoup the money--I am not certain that criminal charges were filed against the contractor. I believe if it is a bad debt, that we are looking at a 2009 deduction and the only possibility I saw for a 2008 deduction was if it should be classified as Casualty/ Theft. Thanks again.

I not only agree with the above, I also note that as the payment was not intended to be a loan, it's not really a debt.

I don't see anything which gives the taxpayer a choice between treatments.

not so. there are debts other than loans.

According to IRS Publication 550: "Insolvency of contractor. You can take a bad debt deduction for the amount you deposit with a contractor if the contractor becomes insolvent and you are unable to recover your deposit. If the deposit is for work unrelated to your trade or business, it is a nonbusiness bad debt deduction."

I disagree with the application. A mere deposit isn't a taxable event by itself. The insolvency triggers the taxable event. Such requires that the contractor is NOT insolvent at the time of the deposit.

bankrupcy."[sic] (NOT that he filed for bankruptcy after entering into the contract.)

If the contractor was already insolvent at the time of the deposit, it's fraud and therefore the casualty deduction applies in 2008.

Companies still operate while under bankruptcy. It's not fraud unless we know all the facts.

rubbish.

If the contractor is in bankruptcy proceedings seeking to reorganize, there is nothing to prevent him from continuing in his business. You are assuming facts not in evidence as to the nature of the contractor's situation and intent.

It's not a debt? It's not a monetary debt, but it is a business debt. The customer paid money and the contractor owed services in return. If the contractor doesn't perform, the customer is legally entitled to get his money back (or the cost to have someone else do the work).

If the contractor filed bankruptcy before entering into a contract with OP, that obligation is still owed. Or, if it's a chapter 11 or

See Revenue Ruling 69-457. An oldie but goodie.

A deposit with a contractor that could not be recovered after failure to perform is considered a nonbusiness bad debt.

Couldn't it also be a rental expense on the 2008 return, specifically on the Schedule E? The amount was paid in 2008.

The 10% + $500 of AGI rule might make the deduction worthless.

That was for construction of a residence, a _personal_ expense.

The case in hand is for a rental property, a _business_ expense.

Seth

I missed that from the original post. That makes it a deposit on real property construction not for personal use. The amount in question would have been part of the cost basis of a capital asset. If lost, it is a capital loss. In this instance it would be deductible when the investment was determined to be worthless.

Either you have a capital loss or a theft if it can be shown that the intent to defraud was present.

However, a deposit with a contractor where the contractor had no intent ever to perform the service leads to a casualty loss (as a fraud similar to embezzlement).

The fact that the OP questioned the treatment as a bad debt by raising the casualty loss issue makes me think there's more going on here than was given; the OP thinks it may be fraud. That possibility must be eliminated before bad debt treatment can prevail as the clear answer.

Update:

Met with the client last week and got a few things straightened out-- attorney was hired, who filed a claim in the bankruptcy case (which was ongoing). Bankruptcy closed this year and my client actually received the majority of his money back (minus attorney fees). Anyway, the loss will go on the 2009 return, and I'll worry about it next year. Thanks for all the input.

P.S. It turns out my client may have been somewhat fortunate that this contractor never started on the addition--it was discovered that he subcontracted out all his work and didn't pay any of the subs.