IRS Offers Clues to Financial Scam Loss Deductions

The Tax Cuts and Jobs Act (TCJA), enacted late in 2017, suspended deductions for most casualty and theft losses from 2018 through 2025, except for losses sustained by natural disasters in designated areas. However, the TCJA also allows taxpayers to continue to deduct theft losses from transactions "entered into for profit." In a new memo, the IRS provides examples of when victims of fraud may— and may not— qualify for tax relief.

Background Information

Before the TCJA, tax law regulations allowed losses to be claimed if damage or destruction resulted from a "sudden, unexpected, or unusual" event. Natural disasters like hurricanes or wildfires typically caused such losses, but they may also have been attributable to incidents like automobile collisions or burst water pipes during a winter freeze.

Furthermore, you could deduct the loss if your personal property was vandalized or stolen. Historically, taxpayers suffering financial losses from theft, fraud or other criminal activities could qualify for deductions under this provision.

The deduction for casualty and theft losses was limited to the unreimbursed annual loss above 10% of adjusted gross income (AGI) after subtracting a $100 "floor" per casualty or other event. For instance, if you had an AGI of $100,000 and suffered a $15,000 loss, your deduction was limited to $4,900.

Subsequently, the TCJA suspended deductions for personal casualty and theft losses, except for losses caused by natural disasters in formally declared "federal disaster areas," from 2018 through 2025. Under the Federal Disaster Relief Act, the 10%-of-AGI limit was eliminated, but the floor per event was increased to $500. These changes apply to federal disaster-area losses occurring between December 28, 2019, and December 12, 2024, and ending no later than January 11, 2025.

New Rules for Personal Theft Losses

Despite suspending deductions for casualty and theft losses, the new IRS memo clarifies that deductions are allowed to the extent the loss came from a transaction seeking profit. In doing so, the agency acknowledges the proliferation of scams targeting unsuspecting victims. All the following requirements must be met to qualify for tax relief:

• The loss results from criminal conduct classified as theft under state law,
• The taxpayer has no reasonable prospect of recovering the stolen funds, and
• The loss arises from a transaction entered into for profit.

The memo details five common scams to help determine when a loss from fraud is deductible:

1. Compromised account scams. Typically, the targeted individual is contacted by a scammer pretending to be a fraud specialist at the victim's financial institution. The scammer tells the person that his or her account has been compromised and the person must transfer funds to a new protected account. Once the transfer is completed, the scammer empties the account and disappears.

2. Pig butchering scams. Here, the taxpayer is tricked into engaging in a fake investment deal — usually involving cryptocurrency. Frequently, the scam begins with a friendship or romantic connection online. The scammer convinces the victim to invest through a website that appears legitimate but is a way to fatten the prey for slaughter.

3. Phishing scams. In this scenario, the scammer accesses the victim's financial accounts through email or social media. For instance, the taxpayer may click on links in emails and share information, allowing the scammer to access the victim's computer. Once the scammer controls the victim's accounts, funds are withdrawn without the owner's knowledge or approval. Note: This scam differs from the others because the victim isn't coerced or tricked into providing the funds themselves.

4. Romance scams. The scammer strikes up a romantic relationship with the victim via social media. Then, the perpetrator asks the target for money to help pay medical or education expenses for a family member or make some other personal request. Once money is paid out — sometimes multiple times — the scammer "ghosts" (abandons) the victim.

5. Kidnapping scams. In these scams, the fraudster plays on the victim's fears rather than greed. The perpetrator contacts a target and claims to have kidnapped a loved one. In exchange for a ransom, the "kidnapper" promises to ensure the safe return of the purported hostage. However, it becomes clear after funds are transferred to an overseas account that the kidnapping never occurred.

The IRS memo indicates that the first three scenarios involve the taxpayer entering into a transaction aimed at turning a profit through financial accounts. Thus, the agency says that these losses are deductible under current law. However, losses due to romance or kidnapping schemes are personal and, therefore, nondeductible.

The IRS memo also touches on Ponzi schemes like the one famously orchestrated by Bernie Madoff. Under a special safe-harbor rule, such losses are deductible only when a theft loss results from a specified fraudulent arrangement operated by a lead figure who's indicted or the subject of a criminal complaint under state or federal law. The IRS memo creates a pathway for deducting Ponzi losses that fall within the specified guidelines.

Remain Vigilant

Suspiciously easy money-making opportunities are usually red flags for scams. In the unfortunate event you're victimized, you may be eligible for tax relief on certain losses as a last resort. Contact your tax advisor for help.