With luck, those words will never leave our mouths. The sad truth, though, is that crooks are getting smarter and it’s really hard to know what nefarious scheme they will come up with next. If you find yourself a victim, can you claim any kind of tax deduction for your loss? The answer is, maybe.
The controlling question is whether your loss is a theft loss under the Code and state law. Section 165 of the Code allows under Section (a) for a deduction for uncompensated losses. Section 165(c) limits the losses for individuals to those incurred in a trade or business, in a transaction entered into for profit, or personal casualty losses [1]. Under Section 165(e) the loss is deductible in the year discovered, but not if there is a reasonable prospect of recovery at the end of that year. There is a Ponzi scheme safe harbor (think Bernie Madoff), even if there is a prospect of some recovery. That option is available to a “qualified investor” who incurred a “qualified loss” from a “qualified investment” in a “specified fraudulent arrangement”. However, it seems there are obviously a few hurdles to get over before qualifying for relief under safe harbor.
Given that background, which of these scenarios result in a loss that may be deductible for the taxpayer?
- The scammer, pretending to be a bank security officer, induces the individual to authorize disbursements from an IRA and brokerage account that are transferred to a foreign bank with a low chance of recovery.
- Taxpayer responds to a cryptocurrency solicitation, makes some money trading, and then invests a larger amount from his IRA and non-retirement funds, only to be locked out of what he thought was his account.
- Taxpayer is duped into giving up login information and his retirement and non-retirement funds are transferred to the scammer without his authorization. There’s a low prospect of recovery.
- Taxpayer enters into an online romantic relationship and is induced to transfer funds for a relative’s medical expenses. Recovery is unlikely.
- Taxpayer is told a relative has been kidnapped and he must pay ransom, or else. He transfers the funds from IRA and non-IRA accounts. The kidnapping never happened, and he will not see that money again.
The last two taxpayers are out of luck in more ways than one. They sustained a theft loss and have no prospect of recovery, but each is considered a personal casualty loss since there was no profit motive. Further, any IRA distributions would be taxable income when they file their returns and any capital gains/losses on distributions from brokerage accounts would need to be reported.
The first three taxpayers have sustained a theft loss (for tax purposes) since the loss was unrecoverable at the end of the year, the transactions were considered theft under state law, and they were incurred in a transaction entered into for profit. However, they too would need to report as income any distribution from a retirement account or capital gains/losses on non-retirement assets.
Although Taxpayer 2 comes close, none of the taxpayers above are eligible for the Ponzi loss safe harbor. In Taxpayer 2’s case, the scammer would need to have been charged with a crime or subject to criminal complaint for this safe harbor to apply.
The examples above are just a taste of the ways scammers try to defraud us, so it pays never to let down your guard. A tax deduction, even if it is available, is small compensation for the psychological and financial trauma of the loss.
[1] For 2018-2025 personal casualty losses are not deductible unless attributable to a federally declared disaster area or to the extent of personal casualty gains.
Contributed by Lois S. Fried, CPA, CFE, CVA, ABV
Information referenced from https://www.currentfederaltaxdevelopments.com
