Tax breaks for lost deposits at failed banks

Bank failures are on the rise. Following a quiet period between June 2004 and February 2007, three banks failed during 2007 and then twenty-five more banks failed during 2008, according to the Failed Bank List published by the FDIC.

There are certainly steps you should take to minimize the risk of losing your money if one of your banks is to fail. But how can you recoup some of your losses if you have deposits exceeding FDIC limits in a bank that has already failed? A good place to start is by figuring out how to maximize the tax breaks you can claim due to your losses.

According to the instructions of IRS Form 4684, Casualties and Thefts, there is special treatment available to losses on deposits in insolvent or bankrupt financial institutions. Depositors can claim their losses as either a casualty loss of personal property on Form 4684 or, if their losses don't exceed $20,000, as a miscellaneous itemized deduction on their Schedule A.

Both of these options come with pitfalls, however. Casualty losses of personal property are only allowable to the extent that the loss exceeds 10% of Adjusted Gross Income (AGI) plus $100. Miscellaneous itemized deductions are only allowable to the extent they exceed 2% of AGI, and are then further limited if a taxpayer is subject to the Alternative Minimum Tax. Plus, individuals can't claim their losses as a Miscellaneous Itemized Deduction if any part of the deposits related to the loss is federally insured.

There is a third option. Taxpayers can claim any losses not previously deducted as a nonbusiness bad debt for the year in which the final determination of the loss occurs, which means they will report those lost deposits as a short-term capital loss. An individual can use his or her capital losses to first offset any other capital gains realized during the year, and then will utilize up to $3,000 of any remaining losses to offset wages and other ordinary income earned that year. Additional unused losses are then carried forward to subsequent years.

IRS Publication 547 applies to all your losses on deposits for the year in that particular financial institution. If you treat the loss as a casualty or ordinary loss, you cannot treat the same amount of the loss as a nonbusiness bad debt when it actually becomes worthless. However, you can take a nonbusiness bad debt deduction for any amount of loss that is more than the estimated amount you deducted as a casualty or ordinary loss. Once you make the choice, you cannot change it without permission from the Internal Revenue Service."

So what's the best route to take if you have money in a bank that fails? Remember, the rules aren't completely straightforward, and you do need to make a decision with the first tax return that you file for the year of the loss. If you suffer any lost deposits in connection with a bank that fails, the best route is to meet with a tax professional to discuss how to best maximize the various tax breaks available to you.

Andrew Schwartz CPA is a partner in the Woburn, MA CPA firm, Schwartz & Schwartz, PC, a firm specializing in the tax issues affecting healthcare professionals and their practices. Andrew is also the founder and editor of FindAGoodCPA.com, a site where taxpayers can locate a CPAs and EAs who have decided to "commit to their niche" and have selected the one industry or profession that best reflects the focus of their practice and their client base. Today's tax code is just too complicated to not specialize. He is also a member of the Massachusetts Society of CPAs.