According to a report from the Federal Trade Commission, Americans lost more than $10 billion from theft and fraud in 2023. With many modern-day fraud schemes perpetuated online and behind a computer screen, victims of theft and fraud are often left with little to no prospect of recovering their stolen funds. In these instances, it is not uncommon for victims to turn to their tax professionals for guidance on whether they may claim a theft loss deduction. Given the limitations applicable to theft losses under the Tax Cuts and Jobs Act of 2017 (TCJA), the answer is not as clear as one would think.
Pre-TCJA Theft Losses
Prior to passage of the TCJA, theft losses were fairly straightforward. Under section 165 of the Code, individual victims of theft could claim a theft loss deduction if they could show: (i) the occurrence of a theft under applicable law; (ii) the amount of the deductible theft loss, which was limited to the taxpayer’s basis in the stolen property; (iii) the proper year to claim the deduction, referred to as the “discovery year”; and (iv) that the theft loss was not reimbursable through insurance or other third-party contracts. Moreover, after the Bernie Madoff fraud, the IRS issued helpful safe-harbor guidance that permitted theft loss deductions to certain qualifying taxpayers.
Post-TCJA Theft Losses
On December 22, 2017, the TCJA was signed into law. Under the TCJA, theft losses arising in 2018 through 2025 are subject to more limitations.
Before addressing the revisions under the TCJA, however, it is important to understand how section 165 works. Under section 165(a), losses sustained during a tax year and not compensated for by insurance or another third party are generally deductible. But section 165(c) limits the deduction for losses if the taxpayer claiming it is an individual.
Generally, section 165(c) divides individual losses into three separate categories. First, section 165(c)(1) permits an individual to claim a deduction for a loss incurred in a trade or business. Second, section 165(c)(2) permits an individual to claim a deduction for a loss not incurred in a trade or business but otherwise incurred in a transaction entered into for profit. Third, section 165(c)(3) acts as a catch-all—it permits an individual to claim a deduction for a loss arising from “fire, storm, shipwreck, or other casualty, or from theft” to the extent the transaction falls outside both section 165(c)(1) and (c)(2).
Although the TCJA left section 165(c) undisturbed, it added a significant limitation to section 165(c)(3) losses. Specifically, for tax years 2018 through 2025, section 165(c)(3) losses are not permitted unless the loss is attributable to a federally declared disaster. Thus, section 165(c)(3) theft losses may not be claimed for tax years 2018 through 2025 unless the loss in question arose in connection with a federal disaster declared by the President of the United States.
What Theft Loss Deductions May Be Claimed Now
For obvious reasons, very few theft losses will be attributable to a federally declared disaster, rendering section 165(c)(3) of little help to victims of internet-based fraud and theft. Given section 165(c)(3)’s limited applicability after the TCJA, tax professionals are left to question whether there is another avenue to claim a theft loss deduction when their clients are victims of theft and fraud.
Significantly, prior IRS guidance may offer some potential help. Indeed, on various occasions, the IRS has concluded that, although the term “theft” is used only in section 165(c)(3), a theft may also occur within the scope of section 165(c)(1) and (c)(2). For example, in Rev. Rul. 66-93, a general partner of a limited partnership embezzled funds from the partnership. When the limited partners discovered the fraud, the general partner was insolvent and unable to reimburse the partnership for the losses. In the ruling, the IRS opined that the partnership’s losses were “an ordinary loss under the provisions of section 165(a) and (c)(1) of the Internal Revenue Code of 1954.”
In more recent guidance, the IRS concluded that a theft loss may also arise under section 165(c)(2). In Rev. Rul. 2009-9, the IRS held that victims of a Ponzi scheme could claim a theft loss deduction under section 165(c)(2) where they reasonably believed that they had made legitimate investments in stocks and other investments. The IRS also noted that the section 165(c)(2) theft loss was not a miscellaneous itemized deduction (the TCJA also prohibits taxpayers from claiming miscellaneous itemized deductions for tax years 2018 through 2025).
Taken together, the revenue rulings seem to support a position that theft losses may be claimed outside section 165(c)(3)—i.e., under section 165(c)(1) or (c)(2). Aside from these revenue rulings, though, there is little authority regarding the deductibility of theft losses under section 165(c)(1) and (c)(2).
Application To Modern-Day Internet Fraud Schemes
In most instances, individual taxpayers who are victims of internet-based fraud will not be involved in a trade or business, at least with respect to the theft. Therefore, section 165(c)(1) would not help. Moreover, as discussed previously, these taxpayers would be unable to claim theft losses under section 165(c)(3) because the theft would not be attributable to a federally declared disaster. Thus, the only potential hope for these taxpayers would be to try to fit under section 165(c)(2), which relates to transactions entered into for profit.
Generally, federal courts have held that taxpayers fall within section 165(c)(2) if they enter into a transaction with the primary intent of making a profit. Because this determination is based on the particular facts and circumstances, whether a taxpayer may claim a section 165(c)(2) theft loss for internet-related fraud under the scant authorities mentioned above would depend, at least in many material respects, on the type of fraudulent scheme.
For example, taxpayers who enter into romance scams would find it difficult to argue that they entered into the transactions with the scammers with the primary intent of making a profit. Generally, in these scams, the fraudster and the victim converse for some time while the scammer establishes a romantic connection with the victim. After the connection is made, the fraudster requests funds from the victim under the guise that the funds are needed for an emergency. When the funds are transferred, the scammer vanishes. Because the funds were transferred for personal reasons and not for profit-driven ones, the transaction would likely fall under section 165(c)(3) and not (c)(2).
However, some online scams seemingly have a for-profit motive. For example, a common scheme involves a scammer reaching out to a victim to solicit funds for a rare investment opportunity (e.g., the purchase of gold, crypto, stocks, etc.). Although the investment turns out to be a scam, there is a much stronger argument in this scenario that the transaction falls under section 165(c)(2) and the reasoning of Rev. Rul. 2009-9.
Conclusion
Theft losses under the TCJA remains a murky area of tax law. Given the uncertainty, a taxpayer seeking to claim a theft loss deduction related to online fraud or theft should consult with a trusted tax professional to determine whether it is reasonable to claim a theft loss deduction in light of the particular facts and circumstances surrounding the theft.
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