No, you can't. Since your FSA money was never taxed, you cannot deduct forfeited FSA funds. From the IRS perspective, you already received a tax break on that money because it was never taxed in the first place.
Initially the money was not taxed to you, this I agree with. This means that the money was subtracted on your W2, then if you did not use it, you are required to include it in income. This gives you basis, you are taxed on it and you can claim a capital loss in my opinion.
But once you don't use the FSA dollars, you are then required to declare it as income, and are then taxed on it. Surely you can then claim a capital loss?
No, you can't claim this as a capital loss (or any other kind of loss) on your tax return. Since the funds were placed in the FSA account pre-tax, you are merely reporting them as forfeited since they were not used for a qualifying purpose. I realize that you lose access to them under the use-or-lose rules, but that is not deductible in anyway - it is the way that the system is designed.
A capital loss refers to a loss on an investment, FSAs are not investments or assets.
@wizardtax wrote:
But once you don't use the FSA dollars, you are then required to declare it as income, and are then taxed on it. Surely you can then claim a capital loss?
This is incorrect. A medical FSA is not reported anywhere on your tax return. The money is subtracted from your income (and not taxed) when it is deducted from your pay. You either spend it on qualified expenses, or lose it. If lost, is it not income, and there is no loss to deduct because you can't take a tax deduction for money that was never included in your taxable income to begin with.
A dependent care FSA is reported on your return using form 2441. One of the first questions is, did you forfeit any money in the account? The money is subtracted from your income (and not taxed) when it is deducted from your pay. If it is forfeit, you just lose it, it is not taxed, and there is nothing to deduct because you can't take a tax deduction for money that was never included in your taxable income to begin with. If you withdrew the money and used it for qualified dependent care expenses, it is tax-free. And if you withdrew it, and didn't use it for qualified expenses, then it is taxable, but there is no other adjustment because you add the money back your taxable income as if it wasn't withdrawn in the first place.