Tax Authorities Reveal Unexpected Decision on Stolen Asset Deductions Post Tax Cuts and Jobs Act
Scams are fetching billions from unsuspecting Americans, with losses reportedly exceeding $12.5 billion in 2025 alone - a rise of 25% from the previous year. But what about the tax implications for these victims? Let's dive into the labyrinth of theft loss deductions, navigating the complexities that arise after the Tax Cuts and Jobs Act of 2017.
Navigating Intense Tax Issues
Tax fraud victims face a host of tax-related challenges. For instance, if they withdraw funds from a taxable retirement account and lose those same funds to theft, they must deal with potential income recognition, discovering if the circumstances support a theft loss, and determining the timing and character of the loss. For clear guidance on these complex topics, refer to my articles here and here.
Theft Loss Deductions: A Complex Web
Even prior to the Tax Cuts and Jobs Act, theft loss deductions were tricky. To claim them, you had to prove three requirements: (i) a theft occurred under governing law, (ii) the limit of the deductible loss based on the stolen asset's basis, and (iii) the proper year to claim the loss, which was limited to when the theft was discovered and whether recovery was possible at the end of that year. Given the intensity of the factual requirements, the IRS often challenged a taxpayer's claim for a theft loss.
The Impact of TCJA:
With the TCJA, claiming a theft loss deduction became even more complicated. Now, taxpayers can only claim theft losses under section 165(c)(3) if they meet the qualifications under the personal casualty loss rules, such as the loss being attributable to a federally declared disaster area. Additionally, the TCJA disallowed miscellaneous itemized deductions, which might include some types of theft losses.
IRS Chief Counsel Delves into the Scam World
Recognizing the scale of scams and their impact on American taxpayers, the IRS Chief Counsel released a memorandum on March 14, 2025. This document addresses various tax issues associated with fraud, providing interpretations for five different scenarios involving compromised accounts, investment scams, phishing attacks, romance scams, and kidnapping scams.
The Speedy Disappearance of Funds
In the first scenario, a fraudster, posing as a specialist from the taxpayer's financial institution, convinces them to transfer their IRA and non-IRA accounts to a new account under the scammer's control. After the funds were transferred, the victim realizes they've been scammed. The Chief Counsel determines that the taxpayer may claim a theft loss under section 165(c)(2) because they entered into the transaction with a profit motive, and the income recognized from the retirement account distribution may increase their basis in the loss.
Cryptocurrency Investment Gone Awry
In the second scenario, a taxpayer falls prey to a "pig butchering" investment scam. After receiving an unsolicited email pitching a cryptocurrency investment, the taxpayer's investments become inaccessible due to an error message. The Chief Counsel determines that the taxpayer has a profit motive and may claim a theft loss under section 165(c)(2), with the income recognized from the retirement account distribution increasing their basis in the theft loss.
Phishing Attacks Tempting Criminals
In the third scenario, a taxpayer is tricked into providing access to their computer by a scammer posing as a representative of their financial institution. The scammer then transfers the funds to an overseas account. The Chief Counsel concludes that, unlike the first two scenarios, the taxpayer never authorized the transfer. To determine the taxpayer's profit motive under section 165(c)(2), the stolen property (i.e., securities accounts) must be considered.
Lost Funds in the Name of Love
The fourth scenario involves a romance scam, where a taxpayer transfers funds to a personal bank account based on false pretenses. The Chief Counsel determines that the taxpayer had no profit motive in this situation and must claim the theft loss under section 165(c)(3). Due to the TCJA, this taxpayer cannot claim the theft loss because the loss was not attributed to a federally declared disaster.
Rescuing a Grandchild with a Fraudulent Funds Transfer
In the fifth scenario, a taxpayer is convinced of a kidnapping by a scammer using sophisticated technology to clone the victim's grandchild's voice. As the taxpayer follows the instructions to transfer funds, they discover the whole situation was a scam. Since the taxpayer had no profit motive, this taxpayer cannot claim a theft loss unless the theft is attributed to a federally declared disaster.
So, What's Next for Scam Victims?
While the IRS Chief Counsel memorandum provides some guidance, it's essential to note that it's not binding precedent or authority. Taxpayers should carefully consider potential IRS arguments regarding the absence of a profit motive, selecting the improper year to claim the loss, and determining if a reasonable prospect of recovery exists before claiming a theft loss deduction. Stick around for more insights on navigating the complexities behind fraud and its repercussions on taxes!
- In light of the IRS Chief Counsel's memorandum on March 14, 2025, it's crucial for tax fraud victims to thoroughly examine the tax implications of their losses, considering potential challenges such as demonstrating a profit motive and selecting the proper year to claim the loss, despite the limitations imposed by the TCJA.
- The complexities surrounding alt investments, like cryptocurrencies, further compound the issues related to tax fraud victims seeking theft loss deductions. Victims must prove a profit motive and determine if the stolen assets qualify as securities accounts to navigate these challenges effectively.
- As various scams continue to pose significant threats and generate losses for Americans, it's essential to understand the intricate tax implications of these crimes - especially when it comes to the interpretation of stolen properties and profit motives - to ensure accurate tax filings and minimize potential IRS scrutiny.
