John, thanks for your additional input. In reconsidering my response I would agree that a 1040 Line 14, from Form 4797 loss deduction is an option but an agressive option. If the service were to pick up the issue I'm sure they would not sustain the treatment. So a client considering this option should be prepared to litigate in order to prevail.

The question is does Reg 1.62-1T(c)4)apply allowing it as a loss from the sale or exchange of property deductible in arriving at AGI or does it fall under Section 63 as an itemized deduction. Rev Rul 61-201 does offer some support for an above the line deduction in that it states that a loss should be afforded the same treatment as a gain, which would definitely go above the line.

The authority conflicting with this would be the definition of miscellaneous itemized deductions under Section 67(b) which specifically excludes losses under Section 165(c)(3)and (d) but not Section 165(c)(2) losses and of course the IRS publications which would indicate a miscellaneous itemized deduction.

Best advice would be to explain it all to the client and let them make the choice. Definitely document the files.