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December 2, 2025

Understanding Tax Relief for Scam Victims

Managing the tax consequences of scams and theft losses can be intricate, especially given legislative shifts that generally confine casualty and theft losses to those linked with disasters. However, if you've been the victim of a scam, there's still an important tax consideration at your disposal.

Traditionally, tax law allowed deductions for theft losses not covered by insurance. But recent changes in the law have tightened these provisions, limiting deductions primarily to disaster-related losses. Still, hope remains. The tax code indicates that if a scam occurs within a transaction intended for profit, a deduction might still be feasible.

Internal Revenue Code Section 165(c)(2) specifically addresses losses from profit-driven activities. This provision means that if your losses from a scam are tied to efforts aimed at profit-making, you can deduct these losses. Recognizing this exception can be a crucial part of recouping financial losses caused by fraudulent schemes.

Eligibility Criteria for Profit-Driven Casualty Losses: Several key criteria must be met for a theft loss to qualify under the profit-motivated exception:

Profit Motive: The chief aim of your transaction should be economic gain. The IRS demands clear proof of a bona fide profit expectation, often entailing extensive documentation to support the profit motive.
Type of Transaction: Eligible transactions usually involve traditional investment vehicles, such as securities or real estate, and other income-generating activities. Social or personal transactions generally do not qualify.
Nature of Loss: The loss must directly result from a profit-oriented transaction, clearly evidenced by financial and legal records. Investment scams or fraudulent financial schemes often qualify if the profit criteria are satisfied.

Applying IRS Guidelines: Understanding the IRS's guidance involves studying memoranda and rulings to clarify deductible losses. A recent IRS Counsel Memorandum (CCM 202511015) provides additional clarity on when such losses are considered deductible:

Investment Scams: Losses from fraudulent schemes can be deductible if the initial investment was made with a credible profit expectation. Documenting the transaction's legitimacy and profit intent is critical.
Theft Losses: Theft losses linked to profit pursuits undergo careful IRS scrutiny and should not be confused with personal engagements.

Tax Implications for Retirement Accounts: Being scammed out of traditional IRAs or tax-deferred pensions can result in significant tax obligations, depending on the account type.

For traditional IRAs or deferred retirement plans, premature withdrawals due to scams generally count as taxable income, potentially elevating your tax bracket and liability. Furthermore, if under 59½, you may face a 10% early withdrawal penalty.

Roth IRAs or qualified plan withdrawals are less severe because contributions are post-tax. As long as the five-year holding rule is met, withdrawals of contributions can be tax- and penalty-free, though earnings might be taxed and penalized if withdrawn early.

Real-World Scenarios:

Example 1: Impersonation Scam - Eligible as a Personal Casualty Loss

Victim 1 was misled by a scammer impersonating a fraud specialist who convinced them to transfer their IRA and non-IRA funds into supposed secure accounts. Key to this deduction is the victim's profit motive, aimed at safeguarding and reinvesting their assets, thus, it qualifies as a theft loss.

Example 2: Romance Scam - Non-Eligible Personal Casualty Loss

Victim 2 transferred funds responding to a fabricated story under a fabricated relationship, lacking any economic motive. Consequently, these losses are non-deductible.

Example 3: Kidnapping Scam - Non-Qualifying Personal Casualty Loss

Victim 3, under duress, transferred funds believing their grandson kidnapped. Despite the deceit, without a profit intent, these losses are not deductible.

Key Takeaways: Analyzing intent and transaction nature is essential to determine qualification for tax-deductible losses.

Documentation: Maintain comprehensive records to document profit motives, especially in investing contexts.
IRS Scrutiny: Heightened attention calls for strict compliance to differentiate qualifying losses clearly.

Seek assistance when encountering suspicious communications, especially before transferring funds. Our office offers fraud prevention and detection guidance. It's crucial to educate family members, particularly the elderly, about these risks, encouraging them to consult for support and protection against scams. Proactive measures safeguard assets and enhance peace of mind.

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