IRS offers guidance theft loss deductions for investment scam victims
The IRS has issued a memorandum explaining situations where victims of investment scams can claim theft loss deductions. The deductions were generally disallowed for individuals under the 2017 Tax Cuts and Jobs Act (TCJA) but are still permitted in certain specified situations, such as when the taxpayer invests in a fraudulent scheme in an attempt to earn a profit.
The IRS Chief Counsel Advice memorandum (CCA 202511015) addressed questions raised by five individual taxpayers who suffered theft losses when they transferred funds from investment accounts to accounts maintained by scammers. Because the memorandum addresses five types of common scams, it provides valuable insights into how the IRS will treat resulting losses.
The memorandum said funds transferred out of investment accounts into scam accounts that purported to be investments are usually deductible by individuals as theft losses because the transfers were part of a profit-seeking transaction. When funds are withdrawn as part of scams that were not profit-motivated, such as kidnapping or romantic scams, the losses are not deductible, as there was no profit motive. The memorandum also found that none of the scams discussed met the criteria for the taxpayers to take advantage of the Ponzi loss safe harbor.
Section 165 of the Internal Revenue Code allows a deduction for losses sustained during a taxable year where the taxpayer was not compensated by insurance and there is no reasonable prospect for recovering those losses. However, the TCJA modified §165 to limit personal casualty losses for the 2018 through 2025 tax years to a few specified situations. The TCJA generally limited the deduction for individuals to losses resulting from a transaction entered into for profit but not connected to a trade or business, incurred in a trade or business, or attributable to a federally declared disaster.
Victims of five common scams
The taxpayers discussed in the memorandum were the victims of five common scams that qualify as criminal fraud, larceny or embezzlement in the states where they reside. In each case, the scammer’s identity is unknown, the fund transfers could not be reversed, and insurance did not cover the losses. All five taxpayers lost funds they had initially invested in IRA and non-IRA brokerage-type accounts that invest in securities and other financial products before transferring them out to accounts run by scammers.
The IRS did not dispute the taxpayers’ claims that their initial brokerage investments were undertaken with a profit motive and that they clearly intended to receive income from those investments. Therefore, prior to transferring the funds to the scammers, the IRS conceded they were invested with the expectation that they would turn a profit. However, it is the nature of the distributions from those accounts that is controlling for theft-loss purposes.
The IRS will look to the taxpayer’s motive for authorizing distributions or transfers out of brokerage-type accounts to determine the character of the transactions. Taxpayers who can establish that their motive for their transfer was to safeguard existing investments or engage in new investments had a profit motive in undertaking the transfers. Taxpayers who made the transfer as part of a non-investment scam had no profit motive in the transaction and can’t claim a casualty loss. For taxpayers who did not authorize a distribution or transfer, the taxpayer took no action relevant to the transaction, and the character of the loss is determined based on their initial motive for the investment.
Compromised account scam
Taxpayer One was the victim of a compromised account scam that involved an impersonator who contacted them, claiming to be a fraud specialist at their financial institution. The scammer said Taxpayer One’s computer and bank accounts were compromised, and attempts were made to withdraw funds. The scammer then convinced Taxpayer One to transfer all the funds in their IRA and non-IRA accounts into new investments created by the scammer. The scammer accessed the new investment accounts and immediately transferred the funds to overseas accounts. In 2024, Taxpayer One discovered the accounts were empty, and the funds had been stolen.
The IRS determined that Taxpayer One authorized the distributions and transfers to safeguard and reinvest all of the funds in new accounts in the same manner as they had been previously invested. Therefore, the losses resulting from the compromised account scam were entered into for a profit under §165(c)(2) and Taxpayer One is entitled to a theft loss for 2024. However, the amount of loss that Taxpayer One may claim is limited to their basis in the property.
Pig-butchering investment scam
Taxpayer Two received an unsolicited email opportunity from a scammer advertising a cryptocurrency investment opportunity that promised large profits. The email directed Taxpayer Two to the website of a new platform that would ostensibly invest in cryptocurrency and use proprietary methods to generate large profits.
After visiting the website, Taxpayer Two found it legitimate and deposited a small amount of cash as an investment. Within a few days, the account balance increased in value, and the taxpayer withdrew their money from the website, reinforcing the belief it was legitimate. A second investment also resulted in increased funds that were successfully withdrawn.
Taxpayer Two then invested significantly more money in the scheme, pulling funds from their IRA and non-IRA accounts and transferring them to the website. After the account balance increased considerably, Taxpayer Two decided to liquidate the investment and withdraw cash from the website, but received an error message and could not reach customer support. An internet search by Taxpayer Two found others who claimed to have been defrauded by the same website and scammer.
The IRS found that Taxpayer Two had transferred the funds from the IRA and non-IRA accounts for investment purposes. Therefore, losses from the scam were incurred in a transaction entered into for profit under § 165(c)(2). As with Taxpayer One, Taxpayer Two must use their basis in the stolen funds to calculate the amount of the deductible theft loss.
Phishing scam
Taxpayer Three received an unsolicited email from a scammer claiming their accounts had been compromised. The email contained official-looking letterhead and was signed digitally by a fraud protection analyst. The email contained a link, phone number and directions to call the analyst to protect the taxpayer’s funds.
Taxpayer Three immediately called the number and communicated with a scammer claiming to be the fraud analyst handling the case. The scammer directed the taxpayer to click on the email link and log into their tax-deferred retirement account so the purported fraud analyst could inspect it for any issues. Clicking the email link gave the scammer access to Taxpayer Three’s computer, and the scammer could identify Taxpayer Three’s account username and password when entered into the login screen. The scammer convinced the taxpayer to do the same with their non-IRA account.
The next day, Taxpayer Three logged into the retirement account to find the funds had been distributed to an overseas account. Unlike Taxpayers One and Two, Taxpayer Three did not authorize the transactions that removed funds from the IRA and non-IRA accounts. Because those transfers were unauthorized, the IRS looked to whether the stolen property was connected to their trade or business, was invested for profit, or held as general personal property.
Taxpayer Three contributed to the accounts for investment purposes and sought to grow the funds to provide income during retirement, establishing a profit motive. The theft of property invested with a profit motive qualifies it as a theft loss and may be deducted up to the taxpayer’s basis in the property.
Romance scam
Taxpayer Four received an unsolicited text message from a scammer who proceeded to develop a virtual romantic relationship with them. The scammer convinced Taxpayer Four that a close relative needed medical assistance, but the scammer could not afford to pay the expensive medical bills. Taxpayer Four authorized distributions from an IRA and non-IRA account to a personal bank account and transferred the money to the scammer’s overseas account to cover the claimed medical expenses.
Following the transfer, the scammer stopped responding to Taxpayer Four’s messages. The taxpayer realized in late 2024 that the romantic relationship was not real and their funds had been stolen. Because Taxpayer Four’s motive was not to invest or reinvest any of the distributed funds, they did not have a profit motive in authorizing the distributions and transfers. Therefore, the losses were not incurred in a transaction but were personal casualty losses under §165(c)(3) that are disallowed under §165(h)(5).
Kidnapping scam
Taxpayer Five was contacted by text and a voice call by a scammer who claimed to have kidnapped their grandson and was holding him for ransom. Taxpayer Five demanded to speak to the grandson and heard his voice begging for help over the phone. The taxpayer was then directed to transfer money to an overseas account and not to contact law enforcement. The scammer had used artificial intelligence to clone the grandson’s voice. No kidnapping had taken place.
Believing the grandson had been kidnapped and under duress, Taxpayer Five authorized distributions from IRA and non-IRA accounts and directed that those funds be deposited in the overseas account provided by the scammer. The next day, Taxpayer Five was able to contact their family and determine that no kidnapping had taken place. Notwithstanding the fraudulent inducement and duress, Taxpayer Five did not have a profit motive in transferring the funds and can’t claim a deduction for a casualty loss.
Ponzi safe harbor
None of the five scammed taxpayers discussed in the memorandum were entitled to take advantage of the Ponzi loss safe harbor provided in Revenue Procedure 2009-20. Taxpayers One, Three, Four and Five are not eligible because the theft losses were not the result of an investment in a Ponzi scheme.
Taxpayer Two fell victim to a pig-butchering scam that could arguably be described as a “specified fraudulent arrangement” described in the revenue procedure. Taxpayer Two’s eligibility depends on the loss being a “qualified loss.” Because the scammer was never identified, charged with any state or federal crime, or the subject of a state or federal criminal complaint, their loss is not a qualified loss, and Taxpayer Two is not eligible to use the Ponzi loss safe harbor.
For more information on casualty and theft loss deductions, check out our on-demand webinar. The webinar is free to NATP’s premium members and provides two CPE credits.