Internal Revenue Code Section 165: Losses, Limits, and Deductions

Internal Revenue Code Section 165 lets you deduct a genuine, unreimbursed loss sustained during the tax year, but only if it fits one of three categories: a loss from a trade or business you operate, a loss from a transaction entered into for profit, or a personal casualty or theft loss tied to a qualifying disaster. Each category carries its own rules for how much you can deduct, when the deduction lands, and whether the loss is ordinary or capital. Getting the category right is the whole ballgame, because it decides whether the loss wipes out your wages this year or trickles against future income at $3,000 a pop.

The Three Categories

Section 165(c) is the gateway, and it sorts every individual loss into one of three buckets.¹

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

Business and investment losses qualify regardless of how the loss happened. Personal losses only qualify when a specific casualty event or theft caused them. A couch that wears out generates no deduction. A couch destroyed in a hurricane might.

Three Requirements Every Loss Must Meet

Before category rules kick in, every Section 165 loss has to clear three baseline tests.

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 down 90% is not sustained 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 property value does not count.²

Insurance and Other Reimbursement Reduce the Loss

The statute bars any deduction for amounts compensated by insurance or otherwise. If you file a claim with a reasonable chance of recovery, the potentially covered portion is not sustained until the claim resolves. Every dollar of reimbursement you receive or reasonably expect to receive reduces your deductible amount. Skipping an insurance claim you were entitled to file does not help; the IRS can treat the potential recovery as expected reimbursement anyway.

Adjusted Basis Is the Ceiling

Your adjusted basis sets the maximum deduction. Adjusted basis is original cost, plus improvements, minus depreciation or other prior reductions. Inherited property with a $300,000 stepped-up basis has a $300,000 starting point. If your basis is zero, there is nothing left to deduct.

Ordinary Versus Capital: Why Character Matters

Trade or business losses generally receive ordinary loss treatment, meaning they offset wages, interest, self-employment income, and other categories of income dollar-for-dollar. Investment losses generally produce capital losses.

Capital losses first offset any capital gains for the year. If losses exceed gains, you can deduct only up to $3,000 of net capital loss ($1,500 if married filing separately) against ordinary income. Any unused amount carries forward indefinitely.³ Several of the special rules discussed below exist precisely because Congress recognized the $3,000 cap can be brutally slow for a large loss.

Limits That Restrict Business Losses

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

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 only offset passive income. You cannot use a passive rental loss to shelter salary or portfolio 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 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 the threshold are not lost permanently; 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

Net Operating Loss Carryforward

When total allowable business deductions exceed gross income, the excess becomes a net operating loss. For losses arising in tax years after 2017, the NOL deduction is limited to 80% of taxable income in any carryforward year. The remaining 20% of taxable income cannot be sheltered. Carrybacks are no longer available for most losses. 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. That fictional sale date decides holding period: if you held the security 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 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; too early or too late and the IRS can disallow it entirely. When the year is uncertain, err toward claiming earlier and file a protective refund claim for the alternative year.

Crypto Is Not a Security Under Section 165(g)

Cryptocurrency and most digital assets do not qualify as “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 for a coin that goes to zero. A token can still generate a deductible loss if you sell it (even for a trivial amount) or arguably if you abandon it by permanently surrendering all rights. Simply holding a token that has crashed, without a sale or abandonment event, does not create a deductible loss for most individual investors.

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 produces an ordinary loss instead of a capital loss trapped behind the $3,000 cap.

Abandonment requires two things: intent to abandon and an overt act that makes the intent unmistakable. Internal memos or board decisions are not enough. The IRS has been explicit that affirmative external actions are required.¹⁰ For tangible property, an overt act 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 need something like a formal surrender of rights to the issuing authority. Letting an asset sit unused does not qualify. Writing an asset 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 applies to stock in qualifying small businesses. Under Section 1244, if you purchased stock directly from a corporation that meets the requirements 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 ($100,000 on a joint return). Ordinary treatment 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 also must 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 exceeding the ordinary loss cap still qualifies as a capital loss on Schedule D.

Investment Fraud and Ponzi Scheme Losses

Victims of Ponzi schemes and similar investment fraud get a dedicated safe harbor. Revenue Procedure 2009-20, modified by Revenue Procedure 2011-58, streamlines these claims.¹² 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,” which is the tax year in which the criminal charge, indictment, or qualifying complaint is filed.¹³

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

Personal Casualty and Theft Losses

Losses from fire, storm, earthquake, flood, vandalism, or similar sudden events qualify as casualties. The event must be sudden, unexpected, or unusual. Progressive damage like termite infestation 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 adjusted basis, reduced by insurance recovery. The restrictive rules below apply only to personal-use property.

The Disaster Requirement

Since 2018, individuals 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.¹⁴ 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, 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. This matters when insurance proceeds exceed your adjusted basis on destroyed property, creating a casualty gain you want to reduce.

The Two Dollar Floors

Personal casualty losses that survive the disaster requirement face two reductions before reaching your return. First, each separate casualty or theft event is reduced by $100. If one storm damages your home and your car, that is one event and one $100 reduction. A second storm months later gets its own $100 reduction.

Second, after subtracting $100 from each event, add up all remaining losses and subtract 10% of your adjusted gross income. Only the amount above that 10% threshold is deductible as an itemized deduction on Schedule A. On $80,000 of AGI, the first $8,000 of combined casualty losses (after the per-event reduction) produces no deduction.¹⁵

How to Measure the Loss

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 reimbursement. A car with $15,000 basis and a pre-casualty fair market value of $8,000, totaled with no insurance, produces an $8,000 loss, not $15,000.

A pre- and post-casualty appraisal is the standard way to prove the FMV decline. The IRS also allows the cost of repairs as a stand-in if the repairs are actually completed, address only the casualty damage, are not excessive, and do not increase the property’s value beyond 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.

When to Claim the Deduction

Timing errors sink otherwise valid losses. The IRS can disallow a legitimate loss claimed in the wrong year.

General rule. Deduct 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 it occurred. An employee embezzling for three years, discovered in 2026, is a 2026 deduction.
Worthless securities. Deduct only in the year the security became wholly worthless. You bear the burden of proving which year that was.⁸
Abandonment losses. Deduct in the year of the overt act of relinquishment, not a later foreclosure or sale date.¹⁰
Pending insurance claims. Wait until the claim settles or is denied before deducting the uncompensated portion.

Disaster losses get a special election. If your loss is from a federally declared disaster, you can choose to deduct it on the return for the year immediately before the disaster occurred, which can accelerate a refund when you need cash for rebuilding.

If you deduct a loss in one year and receive a recovery later, the recovery is income in the year received, but only to the extent the original deduction actually reduced your tax. A $10,000 casualty loss that saved nothing because you were in the alternative minimum tax that year produces no income when recovered. The original return is not amended; the adjustment happens entirely in the recovery year.

Where the Loss Goes on Your Return

Reporting depends on the character of the loss and the property involved.

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

Documentation That Protects the Deduction

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 FMV decline, or the amount of any reimbursement. Keep the following for every loss:

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. Revenue Procedure 2011-58
13
IRS.gov. Instructions for Form 4684 – Casualties and Thefts (2025)
14
Internal Revenue Service. Topic No. 515, Casualty, Disaster, and Theft Losses
15
Internal Revenue Service. Publication 547 (2025), Casualties, Disasters, and Thefts – Section: Deduction Limits
16
Internal Revenue Service. About Form 4797, Sales of Business Property
17
Internal Revenue Service. Instructions for Form 4797 (2025)