Internal Revenue Code Section 165: Business, Casualty, and Theft Losses

Internal Revenue Code Section 165 is the federal statute that allows you to deduct losses on your tax return, and it recognizes three categories for individuals: losses from a trade or business, losses from transactions entered into for profit, and personal casualty or theft losses tied to a declared disaster. Every deductible loss has to be sustained during the year, reduced by any insurance or other reimbursement, and capped at your adjusted basis in the property. Which category your loss falls into controls almost everything that follows: whether it offsets ordinary income dollar-for-dollar, gets squeezed through the $3,000 capital loss cap, or has to clear two additional floors before anything hits your return.¹

The Three Categories Section 165 Allows

Section 165(c) draws hard lines between the losses an individual can deduct. Getting the category right is the first and most consequential step.

Trade or business losses: losses from property used in a business you actively operate. These generally produce ordinary loss treatment and offset any type of income.
Profit-seeking transaction losses: losses from investments or other activities pursued for gain but not rising to the level of a trade or business. Stocks, bonds, rental real estate, a failed side venture. These typically produce capital losses with much tighter deduction limits.
Personal casualty and theft losses: losses on personal-use property from events like fires, storms, earthquakes, or theft. For 2026, these are deductible only if they stem from a federally declared disaster or a qualifying state-declared disaster, and they face two additional dollar floors.¹

Business and investment losses are available regardless of how the loss happened. Personal losses only qualify when caused by a specific casualty event or theft. A couch that wears out from normal use produces no deduction. A couch destroyed in a hurricane might.

Baseline Tests Every Loss Must Pass

Before any category-specific rule applies, three threshold requirements have to be met.

The Loss Must Be Sustained

A loss is sustained when a completed, closed transaction fixes the amount with no realistic prospect of recovery. A stock that drops 90% in value is not a sustained loss while you still hold it. The loss crystallizes when you sell or when the shares become entirely worthless. An expected future loss or a mere decline in value does not qualify.²

Insurance and Other Reimbursement Comes Off First

The statute bars any deduction for amounts compensated by insurance or otherwise. If you file an insurance claim with a reasonable chance of recovery, that portion is not considered sustained until the claim resolves. You reduce the deductible amount by every dollar you receive or reasonably expect to receive. If you choose not to file a claim you were entitled to, the IRS can treat the potential recovery as expected reimbursement and reduce your deduction anyway.¹

Adjusted Basis Sets the Ceiling

Your adjusted basis is your original cost plus improvements, minus depreciation or other reductions already claimed. That number caps the loss. If you inherited property with a stepped-up basis of $300,000 and it was destroyed, your maximum loss starts at $300,000 before applying any other limits. If your adjusted basis is zero, there is nothing left to deduct.

Business Losses Versus Investment Losses

Losses from a trade or business generally receive ordinary loss treatment and offset wages, interest, self-employment income, and any other income category dollar-for-dollar. Losses from investment transactions produce capital losses, which must first offset any capital gains for the year. If capital losses exceed gains, you can deduct only $3,000 of net capital loss against ordinary income per year ($1,500 if married filing separately). Any remaining capital loss carries forward indefinitely.³

That cap has real consequences. A $50,000 stock market loss with no offsetting gains would take roughly 17 years to fully deduct against ordinary income. The capital-versus-ordinary distinction is one of the most consequential characterization questions in the tax code, and several of the special provisions below exist precisely because Congress recognized how slow the capital loss limit can be.

Limits That Can Still Block a Business Loss

Calling business losses “fully deductible” needs an asterisk. Three separate regimes can delay or cap even legitimate trade or business losses.

Passive Activity Loss Rules

If you own a business or rental property but do not materially participate in its operations, losses from that activity are passive. Passive losses can only offset passive income. You cannot use a passive rental loss to shelter your salary or investment income. Suspended passive losses carry forward and become fully deductible when you dispose of your entire interest in the activity in a taxable transaction.⁴

Excess Business Loss Limitation

Even after the passive activity rules are satisfied, noncorporate taxpayers face a cap on total business losses they can deduct in a single year under Section 461(l). The threshold is adjusted annually for inflation. Business losses exceeding it are not lost; they convert into a net operating loss carryforward.⁵ The at-risk rules and passive activity limits apply first, before the excess business loss calculation.⁶

The 80% NOL Deduction Cap

When total allowable business deductions exceed your gross income for the year, the excess is a net operating loss. For NOLs arising in tax years after 2017, the deduction in any future carryforward year is limited to 80% of that year’s taxable income. The remaining 20% stays taxable no matter how large your carryforward is. Carrybacks are no longer available for most losses, but carryforwards continue indefinitely.⁷

Worthless Securities

A stock, bond, or stock right that becomes completely worthless during the tax year is treated as if you sold it for zero on the last day of that year. The fictional sale date determines whether the loss is short-term or long-term: held for more than one year as of December 31, the loss is long-term.⁸

Proving total worthlessness is the hard part. A 99% drop in price is not enough. You need objective evidence of zero liquidation value and no reasonable prospect of recovery. Bankruptcy, corporate dissolution, or permanent cessation of business operations all work. A stock trading at pennies on a speculative exchange may still retain some theoretical value, which can block the deduction. The year you claim must be the year worthlessness actually occurred. If you are unsure of the exact year, claim earlier and file a protective refund claim for the alternative year.

Crypto Does Not Qualify as a Worthless Security

Cryptocurrency and most digital assets are not “securities” under Section 165(g). The IRS has determined that crypto tokens are not shares of stock, bonds, or other instruments listed in the statute’s definition.⁹ You cannot claim a worthless-security deduction on a coin that goes to zero. A crypto token can still generate a deductible loss if you sell it (even for a trivial amount) or arguably abandon it by permanently surrendering all rights. Simply holding a crashed token, without a sale or abandonment event, produces no deduction for most individual investors. The analysis may differ for crypto held in a trade or business.

Abandonment Losses

When you permanently give up all rights to property without receiving anything in return, the result is an abandonment loss. This is often more favorable than selling for a nominal price, because abandonment of business or investment property typically generates an ordinary loss, while a sale would produce a capital loss subject to the $3,000 annual cap.

Claiming abandonment requires two things: the intent to abandon and an overt act that makes that intent unmistakable. Internal company memos or board decisions are not enough. The IRS requires affirmative external action.¹⁰ For tangible property, that might mean permanently vacating the premises, notifying the landlord or lender in writing that you are relinquishing all interest, or physically removing and discarding the property. For intangible assets like patents or copyrights, you would need to formally surrender the rights to the issuing authority or publicly release them. Letting an asset sit unused does not qualify. Writing it off on your books does not qualify. The deductible amount is your adjusted basis on the date of the overt act.

Section 1244 Small Business Stock

One of the most valuable exceptions to the capital loss limit is Section 1244. If you purchased stock directly from a qualifying small business and the stock later becomes worthless or is sold at a loss, you can treat up to $50,000 of the loss as ordinary rather than capital, or $100,000 on a joint return. Ordinary treatment means the loss offsets wages and other income dollar-for-dollar, bypassing the $3,000 cap entirely.¹¹

The corporation must have been a “small business corporation” when it issued the stock, meaning the total money and property it received for all stock, capital contributions, and paid-in surplus did not exceed $1,000,000. It must also have earned more than half of its gross receipts from active business operations rather than passive sources like rent, royalties, dividends, or interest during the five-year period before the loss. Any loss above the $50,000 or $100,000 ordinary cap still qualifies as a capital loss on Schedule D.¹¹

Casualty and Theft Losses

Losses from fire, storm, earthquake, flood, vandalism, or similar sudden events qualify as casualty losses. The event must be sudden, unexpected, or unusual. Progressive deterioration like termite damage or gradual erosion does not count. Theft losses cover larceny, embezzlement, robbery, and similar taking that is illegal under the law where it occurred.²

Business and investment casualty or theft losses remain fully deductible against the property’s adjusted basis, reduced by any insurance recovery. The restrictive rules below apply only to personal-use property.

Personal Losses Must Come From a Declared Disaster

Since 2018, individual taxpayers can deduct personal casualty and theft losses only if the loss is attributable to a federally declared disaster. A tree falling on your car during a routine storm that did not trigger a federal disaster declaration produces no deduction. The same tree falling during a declared hurricane does.¹² Beginning in 2026, Congress expanded this rule to also cover certain state-declared disasters.

One narrow exception. If you have personal casualty gains for the year (for instance, insurance proceeds that exceed your adjusted basis on destroyed property), you can use personal casualty losses that are not from a declared disaster to offset those gains. Only the net gain, if any, is taxable.¹²

The $100 and 10% Floors

Personal casualty losses that survive the disaster requirement still face two reductions. First, each separate casualty or theft event is reduced by $100. One storm that damages both your home and your car is a single event with one $100 reduction. A second storm months later gets its own $100 reduction.¹³

Second, after the per-event reduction, you add up all remaining losses and subtract 10% of your adjusted gross income. Only the amount above that threshold is deductible as an itemized deduction on Schedule A. For someone with $80,000 in AGI, the first $8,000 of combined casualty losses (after the $100 reductions) produces no deduction at all.¹³

Measuring the Loss on Personal Property

For personal-use property, the loss is the lesser of your adjusted basis or the decline in fair market value caused by the casualty, minus any insurance or other reimbursement. If your car had an adjusted basis of $15,000 but a pre-casualty fair market value of only $8,000, and it was totaled with no insurance, your loss is $8,000.

A professional appraisal before and after is the standard way to prove the value decline. The IRS also allows the cost of actually completed repairs as a stand-in for the FMV decrease, as long as the repairs address only the casualty damage, are not excessive, and do not raise the property’s value above its pre-casualty condition. For personal residential property, a safe harbor lets you use the lesser of two independent licensed contractor estimates when the loss is $20,000 or less.²

Investment Fraud and Ponzi Scheme Losses

Victims of Ponzi schemes and similar investment fraud face unique challenges in proving the year of the theft, the amount stolen, and recovery prospects. The IRS created a safe harbor under Revenue Procedure 2009-20, later modified by Revenue Procedure 2011-58, to streamline these claims.¹⁴

Under the safe harbor, you can deduct 95% of your qualified investment (minus actual recoveries and expected insurance or SIPC payments) if you are not pursuing third-party lawsuits, or 75% if you are pursuing or intend to pursue third-party recovery. The loss is claimed as a theft loss in the “discovery year,” meaning the tax year in which the criminal charge, indictment, or qualifying complaint is filed.¹⁵

The safe harbor treats the entire deductible amount as a theft loss from a profit-seeking transaction. That bypasses the personal casualty floors and the disaster requirement. It also bypasses the $3,000 capital loss cap, because the loss is characterized as an ordinary theft loss from an investment activity. It is one of the few situations where a large investment loss can offset ordinary income in a single year.

Timing: What Year to Claim the Loss

Timing errors are where many loss deductions fall apart. The IRS can disallow a loss claimed in the wrong year even if the loss itself is legitimate.

General rule: deduct the loss in the year the transaction closes and the amount becomes fixed with no realistic prospect of recovery.
Theft losses: deduct in the year you discover the theft, not the year the theft actually occurred. If an employee has been embezzling for three years but you find out in 2026, the loss is a 2026 deduction.
Worthless securities: deduct only in the year the security becomes wholly worthless. You bear the burden of proving which year that was.⁸
Abandonment losses: deduct in the year you perform the overt act of relinquishment, not a later foreclosure or sale date.¹⁰
Pending insurance claims: you cannot deduct any portion of a loss for which you have a reasonable prospect of reimbursement. Wait until the claim settles or is denied before deducting the uncompensated portion.²

Federally declared disaster losses get a special election: you can choose to deduct them on the return for the year immediately before the disaster occurred. That can accelerate a refund when you need cash for rebuilding.

Where the Loss Goes on Your Return

The form depends on the character of the loss and the type of property.

Ordinary business losses are reported on Form 4797 (Sales of Business Property) and flow through to offset ordinary income on Form 1040.¹⁶
Capital losses from investments or worthless securities are reported on Form 8949 and summarized on Schedule D. Net capital losses exceeding gains are capped at $3,000 per year against ordinary income, with the excess carried forward.³
Personal casualty and theft losses go on Form 4684 and then on Schedule A as an itemized deduction, unless you elect qualified disaster loss treatment that adds the loss to your standard deduction.¹⁷
Section 1244 stock losses: the ordinary portion (up to $50,000 or $100,000 joint) goes on Form 4797. Any excess is a capital loss on Schedule D.¹⁷

Documentation to Keep

A loss deduction is only as strong as the records behind it. The IRS can disallow the entire claim if you cannot substantiate adjusted basis, the fair market value decline, or the amount of compensation received. Hold onto:

Proof of basis: purchase receipts, closing statements, records of capital improvements, and depreciation schedules.
Proof of value decline: professional appraisals before and after the casualty, repair estimates from licensed contractors, or evidence of total destruction.
Insurance records: copies of claims filed, settlement letters, and denial notices.
Event documentation: police reports for theft, FEMA disaster declarations for personal casualty losses, and photographs of damage.
Worthlessness evidence: bankruptcy filings, dissolution records, SEC suspension notices, or financial statements showing zero net assets.

For abandonment losses, written correspondence surrendering your rights is the single most important piece of evidence. An internal decision to abandon property that was never communicated externally will not survive an audit.¹⁰

1
Office of the Law Revision Counsel. 26 USC 165 Losses
2
Internal Revenue Service. Publication 547 (2025), Casualties, Disasters, and Thefts
3
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
4
Office of the Law Revision Counsel. 26 U.S. Code 469 – Passive Activity Losses and Credits Limited
5
Internal Revenue Service. Excess Business Losses
6
IRS.gov. 2025 Instructions for Form 461 Limitation on Business Losses
7
Office of the Law Revision Counsel. 26 USC 172 Net Operating Loss Deduction
8
Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses – Section: Worthless Securities
9
IRS.gov. Memorandum Number 202302011 – Applicability of IRC Section 165 to Cryptocurrency That Has Declined in Value
10
IRS.gov. Revenue Ruling 2004-58 Section 165 Losses
11
Office of the Law Revision Counsel. 26 USC 1244 Losses on Small Business Stock
12
Internal Revenue Service. Topic No. 515, Casualty, Disaster, and Theft Losses
13
Internal Revenue Service. Publication 547 (2025), Casualties, Disasters, and Thefts – Section: Deduction Limits
14
Internal Revenue Service. Revenue Procedure 2011-58
15
IRS.gov. Instructions for Form 4684 – Casualties and Thefts (2025)
16
Internal Revenue Service. About Form 4797, Sales of Business Property
17
Internal Revenue Service. Instructions for Form 4797 (2025)