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December 2, 2025

Understanding Tax Deductions for Scam and Theft Losses

Navigating through the financial repercussions of scams and theft losses can be challenging, particularly as recent legislative updates generally restrict casualty and theft losses to disasters. However, if you've been scammed, there remains a critical tax option for you to explore.

Traditionally, tax laws allowed deductions for theft losses not covered by insurance. Although the law has evolved, restricting deductions primarily to disaster-related losses, there is hope. The tax code acknowledges that if you were scammed while engaging in a transaction with a profit motive, you might still qualify for a deduction.

Internal Revenue Code Section 165(c)(2) is tailored for losses tied to profit-driven activities. If the financial losses from a scam were related to ventures intended to yield a profit, you might deduct these losses, even without a disaster declaration. Grasping this exception can offer vital relief, allowing you to reclaim some financial equilibrium after being defrauded.

Eligibility Requirements for Profit-Driven Losses: To qualify for the profit-motivated deduction, stringent criteria must be met:

Profit Motive: The primary objective of the transaction should be economic benefit. The IRS requires substantial evidence of a bona fide expectation of profit, with case law and IRS rulings emphasizing this, often mandating considerable documentation to endorse the profit intent.
Type of Transaction: This often involves traditional investment vehicles such as securities or real estate. Social or personal activities typically lack the profit motive needed for this deduction.
Nature of Loss: The loss must be directly tied to the profit-targeted transaction, demonstrated through detailed financial records and legal documentation.

Applying IRS Guidance: Utilizing this deduction often involves evaluating IRS memoranda and rulings. A recent IRS Chief Counsel Memorandum (CCM 202511015) provides scenarios where such losses are deemed deductible:

Investment Scams: Losses from fraudulent investments can be deductible if the original investment was made with a legitimate expectation of profit. Verification through documentation such as correspondence with the scammer, contracts, and monetary proof is essential.
Theft Losses: Profit-driven theft is particularly scrutinized by the IRS, which demands that these losses occur in profit-seeking transactions, unlike personal activities like informal lending.

Adverse Tax Ramifications: Being defrauded out of your IRA or tax-deferred pension funds can yield significant tax consequences, contingent on the account type.

For traditional IRAs or tax-deferred plans, premature withdrawals due to a scam are taxable, potentially elevating your tax bracket and liability. Moreover, if below 59½, a 10% early withdrawal penalty may apply, adding financial strain. For Roth IRAs, though immediate tax repercussions are minimal since contributions were after-tax, premature earnings withdrawals may face taxes and penalties if not prompted by qualifying reasons.

Here are examples of when scams or thefts qualify as casualty losses:

Example 1: Impersonation Scam - Qualifying Personal Theft Loss

Taxpayer 1, deceived by a scammer posing as a "fraud specialist," transferred funds to overseas scam-controlled accounts, believing they were protected investments. Due to the profit-oriented motive underlying these actions, the losses qualify as deductible theft losses.

Tax Implications:

The loss is deductible on Schedule A if itemizing.
The taxpayer is taxed on IRA distributions, recognizing gains or losses on non-IRA accounts. Early withdrawal penalties apply if under 59½.
If sufficient resources exist, funds can be rolled back into the IRA within 60 days, negating some implications.

Example 2: Romance Scam - Non-Qualifying Personal Loss

Taxpayer 2 fell for a romance scam, providing funds for personal instead of profit motives. Hence, these losses do not qualify under Section 165(c)(3) for a deduction.

Example 3: Kidnapping Scam - Non-Qualifying Personal Loss

In a frightful kidnapping scam, Taxpayer 3 authorized fund transfers hoping for a safe outcome, lacking any profit motive, and thereby not qualifying for deductions.

Critical Insights:

Documentation and Intent: Document intent clearly, especially in investment scenarios, to prove profit motives.
Scrutiny and Compliance: IRS scrutiny of non-disaster losses demands precise compliance to differentiate qualifying from non-qualifying losses.

Consulting professionals when receiving suspicious communications is vital to avoid losses. Educating family, especially the elderly, about these risks can prevent deception. A proactive approach is key to asset preservation and peace of mind.

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