Does the potential criminal value of objects have any legal uses, such as in tax deductions?

Question

Suppose someone has evidence that could be used to blackmail a billionaire. The person knows that it is illegal and immoral to use and does not use it, but if they wanted to, it would be easy to sell to a criminal buyer at say, $100,000. If that evidence were destroyed in a natural disaster, could the loss of this valuable-if-used-illegally evidence be used as a tax write-off in their US federal taxes? Assume that the situation is otherwise such that a tax write-off would be possible, like that it was a declared federal disaster and so was not suspended in the 2018 tax reform.

In general, is there any legal use for the value of an object which is derived purely from a potential illegal use (that is never acted upon)? I have read that illegally obtained income should be reported to federal taxes and that even expenses operating illegal businesses can be deducted. While those are related situations, they both require actually having committed a crime. In this case, I am considering whether there is a hypothetical where no crime is ever committed but someone legally obtains value from a potential illegal action. I would be interested in examples outside of tax write-offs if they exist, it's merely the only potential example I can think of.

Answer 1

Limitations On The Casualty Loss Deduction And 280E

There is a tax deduction for casualty losses from natural disasters in U.S. federal income tax law and there is also a deduction for theft losses (the broader deduction for all casualty losses was repealed).

The deduction is limited to the taxpayer's "adjusted basis" in the property destroyed (typically, the purchase price, plus capital improvements to the property, less depreciation deductions taken) or fair market value, whichever is smaller.

It is also only available after the first loss of $100 per event, and only to the extent that this loss exceeds 10% of adjusted gross income and the taxpayer itemizes his or her deductions. In some circumstances, if the loss exceeds your income in the year it occurs, it can result in a net operating loss (NOL) carry forward to future years.

Income from criminal activities is generally speaking, subject to federal income taxation, and expenses incurred in connection with those criminal activities are generally deductible (unless the criminal activities involve drug dealing for which expenses other than costs of goods sold are not deductible pursuant to 26 U.S.C. § 280E and related case law).

But, it doesn't follow that the fair market value of property is determined based upon a highest and best use that is illegal. In the absence of an actual sale of the property, its fair market value would probably be its highest and best use in a legal purpose. And, unless money was spent to acquire the property primarily useful for illegal purposes, the adjusted basis of the property might be zero or negligible.

For example, if you used your own efforts to create a compromising video of someone, rather than paying someone else for the video and rather than paying someone else to make the video, your adjusted basis in the video would merely be the out of pocket cost incurred for the USB-drive or other medium that the video was stored upon, which would usually be less than $100 and hence not entitled to the casualty loss deduction. This would be true even if the video had a legal highest and best use (e.g. for sale to a legitimate documentary film maker) of $100,000, since that would not be your adjusted basis in the property.

Who Owns The Property?

Also, if the property was stolen from someone else, it would not be deductible as a casualty loss, because you wouldn't have ownership of the property, not even voidable title to it, even though you had possession of it.

5th Amendment Waiver Issues

Another consideration is that to claim the tax loss, you would have to disclose your ownership of the property destroyed and the basis for your valuation to the IRS and that information could be used against you in a criminal prosecution because that disclosure would waive a 5th Amendment privilege against self-incrimination. When an attempted felony is revealed, that would be a high price to pay for a tax break.

Casualty Loss Or Abandoned Intangible Property?

It also isn't obvious that the deduction extends to losses other than damage to tangible real property and tangible personal property, as opposed to losses of intangible property. Arguably, intangible property is instead a loss from "abandonment of intangible property" under 26 U.S.C. §§ 165 and 988, which is are different tax code sections than the now very narrow casualty loss deduction.

One recent case (from 2018) of someone trying to take a deduction for abandonment of intangible property in connection with a probably illegal scheme resulting in the IRS prevailing, although the reasoning got more in the weeds of poor documentation of the loss, rather than making a categorical determination that no such loss could ever be allowed as a matter of law.

The Repealed Cost Of Earning Income Deduction

Also related is the fact that the itemized deduction for costs of earning income outside of a trade or business (e.g. investment related expenses) has been repealed. So, the IRS could argue that blackmailing people is not a trade or business, and that therefore what amounts to a business expense cannot be allowed as an itemized deduction, even if the expenditures for the property intended for illegal use was acquired for a substantial amount of money.

Answer 2

I do not think so.

To establish a tax loss because of a loss of valuable property, one must claim the value of the lost or destroyed property. I do not think that the unrealized blackmail potential of documentation for possible blackmail would be a valid loss, any more than a hammer's possible use for burglary would be.

Now if there was a legitimate use, that would perhaps be different. For example, if this documentation would be of value in writing a tell-all book about the righ person, that would not be criminal. On the other hand, the possible value derived from that use might well be too speculative to be allowed as a tax loss.

Usually top v;laim a tax loss the value of the lost, damaged, or destroyed property must be objectively established, such as a ring for which a receipt was retained or a work of art appraised by an appropriate expert. Also, losses covered by insurance are not claimable on one's taxes.