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My Bank Became Insolvent, What Are the Tax Implications for Nonbusiness Funds?

In the recent volatile economic climate, many taxpayers are finding that their financial institutions are at risk of becoming insolvent. Most nonbusiness bad debts may only be reported as a short-term capital loss on Schedule D when the amounts are actually determined (which due to the length of time to liquidate a bank might be several years after the bank shuts down). However, there is an exception with respect to insolvent financial institutions. There are two alternatives, first passed by Congress in the 1980s. That first allows individuals to treat losses on nonbusiness deposits as casualty losses in the year they can be reasonably determined. The second, more limited, alternative is to allow taxpayers to treat such losses as miscellaneous itemized ordinary losses.

Casualty or Ordinary Loss

Taxpayers can elect to take losses for any year in which the loss can be reasonably determined. The taxpayer may treat this loss as either a casualty or ordinary loss. If either one of these elections is made, the individual cannot treat the estimated amount as additional nonbusiness bad debt when the actual loss is determined. However, in the year the actual loss is determined, the individual can deduct a nonbusiness bad debt for any portion of the loss above the estimated amount that was deducted as a casualty or ordinary loss. For either option, the taxpayer must treat the losses consistently for each particular financial institution. Once the choice is made, it cannot be changed without permission from the IRS.

If the taxpayer elects to treat the loss as an ordinary loss, the individual should report the loss as a miscellaneous itemized deduction on Schedule A. The maximum amount the taxpayer can claim is $20,000 ($10,000 if married and filing separately), reduced by any expected state insurance proceeds. The loss is subject to the 2% of the adjusted gross income (AGI) limit. The individual cannot claim an ordinary loss if any part of the deposit is federally insured. Therefore, this practically limits the ordinary miscellaneous itemized deduction to losses suffered from institutions that do not have FDIC insurance. This deduction is not allowed for purposes of calculating the taxpayer's alternative minimum tax (AMT).

Another option a taxpayer can elect is to treat the loss as a casualty loss; the loss must exceed $100 as well 10% of the taxpayer's AGI to qualify. This option is allowed whether or not any of the deposit is federally insured but, of course, only to the excess of expected FDIC or other reimbursement. This option is also reported as an itemized deduction on Schedule A (just not subject to the 2% miscellaneous limitation). By treating the loss as a casualty loss, a taxpayer does not have to add back the loss for AMT purposes as is the case if the taxpayer elected to treat the loss as an ordinary miscellaneous itemized loss.

Capital Loss

The taxpayer's third option is to deduct the loss as a nonbusiness bad debt and deduct it as a short-term capital loss. Note: The taxpayer must wait until the year the actual loss is determined to deduct the loss as a nonbusiness bad debt in that year. If the taxpayer elects this option, the individual is allowed a maximum $3,000 annual deduction (after offsetting with any capital gains). Any excess loss is allowed to be carried forward until fully utilized.

Income and Expense Recognized After Election

If any amount deducted as a loss in a earlier year is recovered, the amount might have to be included in income in the year it is recovered, depending on what affect it originally had on that year's tax liability. If the deduction did not reduce the tax liability in the earlier year, that part of the recovery would not need to be included in income. Likewise, if a taxpayer's estimated loss is less than the actual loss, the taxpayer can claim the difference as a nonbusiness bad debt for the year in which the final determination of the loss occurs.

For more information, please contact Kira Wheat at 312-980-3331, Alex Winkworth at 312-980-3251 or your Blackman Kallick representative.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.