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

Internal Revenue Code Section 165 loss deductions cover losses that are complete, not reimbursed by insurance or other recovery, and connected to a business, a profit-seeking transaction, or a qualifying casualty or theft of personal property. How much you can deduct, when you can deduct it, and whether the loss offsets ordinary income or only capital gains depend on which of those categories the loss falls into and what other Code provisions apply on top.¹

The Three Baseline Requirements

Every deduction under Section 165 has to clear the same three gates before the type of loss even matters.

The loss must be sustained during the tax year. That means a completed, identifiable event has locked in the loss. A drop in your home’s market value is not a deductible loss until you sell.¹

The loss must be genuine. The IRS can disallow a deduction for a paper loss or a transaction arranged solely to generate a tax benefit.

The loss must be net of compensation. Insurance proceeds, disaster relief grants, and legal settlements all reduce the deductible amount. If your insured property is damaged and you haven’t filed a claim, you cannot skip the insurer and deduct the full loss.

The Three Categories of Losses Individuals Can Deduct

Section 165(c) restricts individual taxpayers to losses in three buckets:¹

Losses from a trade or business you actively operate.
Losses from a transaction entered into for profit that isn’t part of a formal business, including sales of stock or rental property at a loss.
Personal casualty and theft losses, meaning losses to property you use personally, but only if caused by a qualifying disaster, fire, storm, or theft.

Corporations and other entities are not subject to this three-category limit and can generally deduct any loss that meets the baseline requirements. The restrictions that follow apply specifically to individuals.

Business and Investment Losses

Losses from operating a business or from profit-seeking transactions get the most favorable treatment. Selling business equipment at a loss, closing a failing business, or disposing of investment property for less than its adjusted basis all produce deductible losses. In their basic form, these are ordinary losses that can offset any income, including wages and self-employment earnings.

The catch is that “fully deductible” carries an asterisk. Several other Code provisions can cap, defer, or recharacterize a loss even after it qualifies under Section 165. Those stacking rules are covered further down.

Worthless Securities

Section 165(g) lets you claim a loss on stocks, bonds, or other securities that become completely worthless during the year, even though there is no sale. The loss is treated as if you sold the security on the last day of the tax year for zero dollars, and that deemed sale date fixes whether the loss is short-term or long-term based on your holding period.¹

“Security” for this purpose includes shares of stock, rights to subscribe for stock, and bonds, notes, or other debt instruments issued by a corporation or government entity in registered form or with interest coupons. The default character is a capital loss, subject to the same $3,000 annual limit against ordinary income ($1,500 if married filing separately) that applies to losses from actual sales.²

Proving worthlessness is where most claims get stuck. You have to show the security has no current liquidating value and no reasonable prospect of regaining value. A penny stock still has value. Cessation of operations, dissolution, or a bankruptcy with nothing left for shareholders is generally what it takes.

Affiliated Corporation Exception

One exception converts the loss into an ordinary loss. If the worthless stock is in a corporation you own at least 80% of by voting power and value, and that corporation earned more than 90% of its gross receipts from active business operations rather than passive income like dividends, rents, and royalties, the loss is ordinary rather than capital.³ Ordinary treatment is far more valuable because it isn’t capped at $3,000 a year.

Ponzi Scheme Safe Harbor

Victims of fraudulent investment schemes face a hard timing question because the fraud can take years to surface. Revenue Procedure 2009-20 provides a safe harbor: you can deduct 95% of your net investment (amounts you put in minus amounts you actually withdrew) if you’re not pursuing recovery from third parties, or 75% if you are pursuing or plan to pursue third-party claims. Either figure is then reduced by actual insurance or SIPC recovery.⁴ The loss goes on Form 4684 with “Revenue Procedure 2009-20” written at the top.⁵

Abandonment Losses

You can deduct a loss when you permanently give up property without selling, exchanging, or transferring it. Walking away from a worthless partnership interest or surrendering rights to property you no longer want are the common examples. There is no buyer and no proceeds, so the loss equals your remaining adjusted basis.

Two things have to be true. You must intend to abandon the property, and you must take an observable act that makes the intent visible to others. Letting property sit idle isn’t enough. For intangible property like a partnership interest, the act usually looks like a formal written notice to the partnership and the other partners.

The character of an abandonment loss is generally ordinary when the walk-away doesn’t involve a deemed exchange. But if the abandonment triggers a deemed distribution or exchange under other Code provisions, the loss can be recharacterized as capital. Partnership interests are the most common trap because partnership liability allocations can create a deemed cash distribution on abandonment.

Personal Casualty and Theft Losses

This is the most restrictive path in Section 165. A loss to property you use personally — your home, furniture, or car — is deductible only if it results from a qualifying disaster or theft. Accidentally breaking a valuable item, or normal wear and tear, doesn’t produce a deduction.

The Disaster Requirement

From 2018 through 2025, the Tax Cuts and Jobs Act limited personal casualty loss deductions to losses caused by federally declared disasters. Starting in 2026, that restriction is permanent but expanded: personal casualty losses are also deductible if they result from a disaster recognized by both the governor of the state (or the mayor of the District of Columbia) and the Secretary of the Treasury.⁶ A wider range of disasters can qualify, but an isolated house fire, car accident, or theft that isn’t tied to a declared disaster still produces no deductible loss.

The $100 Floor and 10% AGI Threshold

Two numerical limits then eat into what you can actually deduct. Each separate casualty or theft event is reduced by $100 first. If a storm damages both your roof and your car, each loss is reduced by $100 separately.⁷ After the $100 reductions, you total your remaining personal casualty losses for the year and subtract 10% of your adjusted gross income. Only the amount above that 10% threshold is deductible.⁸ For someone with $80,000 AGI, the first $8,000 of combined losses (after the $100 reductions) produces no deduction at all. Moderate losses rarely generate a meaningful tax benefit.

Insurance Filing Requirement

If insurance covered the personal-use property, you must file a timely claim before deducting any portion of the loss.⁷ The deductible amount is whatever remains after insurance proceeds are subtracted.

How the Loss Is Measured

The basic rule under Section 165(b) is that the deductible loss cannot exceed your adjusted basis, which is what you paid plus improvements, minus depreciation and other adjustments.¹

For casualty losses, the regulations add a second measurement. The deduction is the lesser of your adjusted basis or the decline in fair market value caused by the casualty, comparing value immediately before and immediately after the event.⁹ There is one exception: if business or income-producing property is totally destroyed and its fair market value before the casualty was less than its adjusted basis, you can deduct the full basis instead of the lower value.

For personal-use real estate, the property and all improvements (buildings, landscaping, fencing) are treated as a single unit when measuring the decline. Business property is measured item by item.⁹ The final figure is reduced by insurance, salvage value, or other compensation received or reasonably expected. A pending claim you reasonably expect to collect on has to be subtracted even if the check hasn’t arrived.¹⁰

When to Claim the Loss

The general rule is that you deduct a loss in the year it is sustained. For sales and dispositions, that’s the year the transaction closes. For business property that becomes worthless, it’s the year worthlessness can be established.

Theft Losses Follow the Discovery Year

You deduct a theft loss in the year you discover it, not the year it happened.¹ If an employee has been embezzling for three years and you find out this year, the loss belongs on this year’s return.

Disaster Loss Prior-Year Election

If your loss occurred in a federally declared disaster area and is attributable to that disaster, you can elect to deduct it on the return for the tax year immediately before the disaster year.¹ That accelerates the refund when you need cash for recovery. If you already filed the prior year’s return, you claim the loss on an amended return.¹¹

Other Rules That Limit Loss Deductions

Qualifying under Section 165 is only the first gate. Several other provisions can cap, defer, or reshape the deduction.

Capital loss limits under Section 1211: capital losses offset capital gains in full, but only $3,000 of excess ($1,500 for married filing separately) can offset ordinary income in a single year. Unused capital losses carry forward indefinitely.²
Passive activity loss rules under Section 469: losses from rental activities and from businesses you don’t materially participate in can only offset income from other passive activities. Excess passive losses are suspended and carry forward until you have passive income or dispose of the entire activity.¹²
Excess business loss limitation under Section 461(l): a cap on net business losses noncorporate taxpayers can deduct against nonbusiness income. For 2026, the cap is $256,000 for single filers and $512,000 for joint filers. Business losses above the cap convert into a net operating loss carryforward.

These rules stack. A rental loss must first qualify under Section 165, then survive the passive activity rules, then survive the excess business loss cap. It’s common for a legitimate loss to produce no current tax benefit because of that layering.

Where the Loss Goes on Your Return

Casualty and theft losses, whether personal or business, are reported on Form 4684, which has separate sections for personal-use property, business and income-producing property, and Ponzi scheme losses.¹³ Personal-use casualty losses flow from Form 4684 to Schedule A as an itemized deduction, and you must include the FEMA disaster declaration number for a federally declared disaster.

Losses from the sale or disposal of business property, including involuntary conversions, go on Form 4797.¹⁴ Investment losses from selling stocks and other capital assets go on Schedule D. Worthless securities also go on Schedule D, with the sale date listed as the last day of the tax year and the sale price as zero.¹⁵

Whatever form applies, keep documentation for both the amount of the loss and the event that caused it. For casualty losses, that means before-and-after appraisals or repair estimates, photographs, insurance correspondence, and the disaster declaration number. For worthless securities, keep records of the company’s dissolution, bankruptcy, or cessation of operations. The IRS rarely questions that a loss occurred; it questions when and how much. Your records need to answer both.

1
Office of the Law Revision Counsel. 26 USC 165 Losses
2
Office of the Law Revision Counsel. 26 U.S. Code 1211 – Limitation on Capital Losses
3
Office of the Law Revision Counsel. 26 U.S. Code 165 – Losses – Section: Worthless Securities
4
Internal Revenue Service. Revenue Procedure 2009-20
5
Internal Revenue Service. Help for Victims of Ponzi Investment Schemes
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Congressional Research Service. The Nonbusiness Casualty Loss Deduction
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Office of the Law Revision Counsel. 26 U.S. Code 165 – Losses – Section: Treatment of Casualty Gains and Losses
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Internal Revenue Service. Topic No. 515, Casualty, Disaster, and Theft Losses
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eCFR. 26 CFR 1.165-7 – Casualty Losses
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eCFR. 26 CFR 1.165-1 – Losses
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eCFR. 26 CFR 1.165-11 – Election to Take Disaster Loss Deduction for Preceding Year
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Office of the Law Revision Counsel. 26 U.S. Code 469 – Passive Activity Losses and Credits Limited
13
Internal Revenue Service. Instructions for Form 4684
14
Internal Revenue Service. About Form 4797, Sales of Business Property
15
Internal Revenue Service. Losses (Homes, Stocks, Other Property)