Deducting capital losses

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Dear Tax Talk,
My brother-in-law started a business with backing from a large corporation. He offered his siblings the chance to invest in the company. He promised that whatever was invested would generate profits if the company did well. Two years later, it failed. My wife and I gave him $15,000 knowing that it was like any other investment. Is there any way to claim this loss?
— Glenn

Dear Glenn,
If it was an investment like “any other,” you can always claim long-term capital loss on Schedule D. The obvious downside is that capital losses can only offset capital gains, with any excess limited to an annual $3,000 deduction.

The IRS closely scrutinizes interfamily losses to determine that they are legitimate business losses and not disguised nondeductible gifts. To this end, you should have adequate documentation that you treated this as you would have any other investment.  Examples would include correspondence, e-mails, financial data and investor agreements.

You might want to discuss the loss with your brother-in-law in hopes of getting better than capital loss treatment — for example, if the ordinary deductions can flow through to you either because it was an S corporation or LLC/partnership. 

You can also check if the stock qualifies under Section 1244 losses, which are deductible as ordinary losses if the company did not exceed certain capitalization levels at the time you received your shares.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.