Deceived and Deductible: The IRS Clarifies Theft-Loss Relief

BY MANOGJNA VADDIRAJU AND DIANDRA ZUNIGA

Financial theft can take many forms, but in today’s world, fraudulent schemes are becoming more and more elaborate. Oftentimes, scammers not only attempt to steal financial property but also pose as the very agents who assist in recovering and safeguarding such property.

There was a time when victims of financial theft could find significant relief in the federal tax code via theft loss deductions. In 2017, however, the Tax Cuts and Jobs Act (TCJA) significantly restricted these deductions—allowing them only to the extent the losses were related to a federally declared disaster.

In March 2025, however, the Internal Revenue Service (IRS) eased these restrictions by issuing an IRS Chief Counsel Memorandum (CCM) that identified situations in which taxpayers can, once again, deduct losses sustained from theft.

The authors, as volunteers with the University of Washington Federal Tax Clinic, work with clients who have suffered financial theft losses. In this article, we will provide an overview of the shifting landscape of tax law and loss limitation. We will also examine some real-world examples from tax clinic clients to illustrate how this new memo can apply to losses from scams and highlight how scammers are targeting victims in ever more sophisticated ways.

A Shifting Landscape: From Roberts to Now

Roberts v. Commissioner—Theft Losses as Non-Reportable Income

Before the IRS published the CCM, taxpayers often relied on Roberts v. Commissioner, 141 T.C. 569 (2013), to claim that amounts reported as income due to a third-party forgery or scam should not be attributed to the victim. Instead, such amounts should be characterized as theft losses, relieving the victim of the obligation to report the fraudulent withdrawals as income.

In Roberts, the taxpayer’s wife forged his signature on requests to withdraw funds—approximately $37,000—from two IRAs in Roberts’ name in 2008. (Roberts, 141 T.C. at 571). Taxpayer Roberts was not aware of the forged requests or that distributions in his name were made until he received the forms 1099-R reporting income from distributions made from his IRAs in 2009. (Id. at 573). The IRA distributions were made to a joint account that was only used by Roberts’ wife, which she used to make large expenditures, including establishing a separate household from Roberts. (Id.). Furthermore, Roberts’ wife electronically filed his 2008 income tax returns, which she had done in the past, indicating his single filing status, without reporting the IRA distributions made in his name. (Id. at 574). The IRS argued that since IRA distributions were made in Roberts’ name, he was the distributee pursuant to Internal Revenue Code (IRC) Section 408(d)(1), and that taxpayer Roberts was also liable for the additional tax on early distributions from qualified retirement accounts, under IRC Section 72(t). (Id. at 579.)

In Roberts, the Tax Court explained that although the payee or distributee of a qualified retirement plan is usually the participant or beneficiary entitled to receive the funds, this is not always the case. Under IRC Section 408(d)(1), the taxable distributee may be someone other than the person in whose name the distribution appears. Applying this principle, the Tax Court found that because the petitioner did not authorize and “did not receive any benefit, directly or indirectly,” from the distributions made from the IRA to his ex-wife, he was not a payee or distributee for purposes of Section 408(d)(1). Accordingly, he did not fail to report income from those distributions.

Tax Cuts and Jobs Act—Limiting Theft Losses

The enactment of the TCJA in 2017 ushered in some of the most sweeping changes to the IRC in three decades. Among its many revisions, the TCJA significantly curtailed the scope of theft loss deductions available under Section 165. Prior to 2017, individuals could deduct uncompensated theft losses, including losses resulting from embezzlement, Ponzi schemes, or identity theft, provided the losses were not covered by insurance or otherwise reimbursed. This deduction had long served as a remedial provision, allowing taxpayers to mitigate the financial impact of criminal activity.

The TCJA fundamentally altered this landscape by limiting the deduction for personal casualty and theft losses to only those arising from federally declared disasters. The statutory amendment, codified in Section 165(h)(5), effectively eliminated the ability of individual taxpayers to deduct most theft-related losses between tax years 2018 and 2025. As a result, victims of common thefts, including investment scams, were no longer entitled to claim deductions unless the theft occurred in connection with a federally declared disaster area.

In July 2025, the One Big Beautiful Bill Act made this approach permanent and expanded it to state-declared disasters as well. As a result, most scam victims can no longer use the personal theft-loss rules and instead must rely primarily on the guidance provided in the March 2025 CCM.

March 2025 IRS Chief Counsel Memo—A Path Forward

As previously noted, the IRS issued its CCM in 2025. In doing so, the IRS shed light on certain situations in which theft loss deductions from scams would be allowed under Section 165(c):

• the taxpayer must have sustained the loss due to illegal taking of property under relevant state law;
• the taxpayer must have no reasonable prospect of recovery; and
• the loss must have been incurred during a profit-motivated activity.

The memo clarifies that to the extent theft losses are deductible under Section 165, they should be treated as though sustained in the year the taxpayer discovered the loss and the deductible amount should be limited to the taxpayer’s basis—generally the amount of the taxpayer’s own money originally invested in the property.

The CCM also indicates that while personal theft losses have now been largely disallowed, theft losses arising from transactions entered into for profit, such as investment activity, remain potentially deductible. In fact, withdrawals from brokerage accounts invested in securities and other financial products are generally considered prima facie evidence of a profit motive. Further, the analysis for determining a profit motive depends upon whether the fraudulent authorization occurred without the knowledge of the victim, as in Roberts, or whether the victim was scammed into authorizing a fraudulent distribution.

In cases like Roberts where the distributions were not authorized by the victim, the relevant analysis is to consider the victim’s motive when they entered into the investment initially. In instances where the victim authorized a distribution but did so because they were misled by a scam, the relevant inquiry is their motivation at the time of authorization. If a profit motive can be established at that point, the transaction is treated as one entered into for profit and therefore deductible, regardless of any intermediate steps taken by the scammer.

The memo also examines several fraud scenarios that share some key features: they constituted criminal violations in the state where the victims resided, the identities of the scammers were unknown, transfers were irreversible, losses were not covered by insurance, victims had no legal recourse, and law enforcement stated there was little to no prospect of recovery. Let’s take a closer look at one of them, the Compromised Account Scam.

In this scenario, Taxpayer 1 was a victim of a “compromised account scam” in which a scammer claiming to be a “fraud specialist” convinced the victim that one of their investment accounts was compromised and advised the victim to quickly move their funds to a new “safe” account. In reality, the scammer controlled this new “safe” account and immediately drained it and transferred the stolen money overseas. When the taxpayer discovered that the account was empty, they contacted their financial institution and law enforcement only to be told that there was little to no prospect of recovery—a prerequisite for a taxpayer seeking a theft-loss deduction under Section 165.

In the CCM, the IRS explains that because (1) the victim was scammed into authorizing the transaction and (2) the motivation behind the transfer of funds was to safeguard an investment and to reinvest in a similar manner, there was a profit motive at the time of the transaction, so the loss would qualify under Section 165. The memo allowed the deduction in this case to the full extent of the stolen funds, noting that the taxpayer would be liable for income tax on the IRA distributions and also any gain or loss on non-IRA distributions.

While the broader rules for personal theft losses remain restrictive, the CCM gives victims of investment scams a clearer pathway for claiming relief under Section 165. Its guidance helps ensure that taxpayers misled into moving their investments are not left without any tax remedy.

Real World Application—Federal Income Tax Clinic

Now let’s take a look at some real-
world examples from our work with the University of Washington Federal Income Tax Clinic earlier this year.

CASE 1: The Gold Coins Scam

One of our clients at the tax clinic had factual circumstances very similar to Taxpayer 1. The client was contacted by a scammer claiming to be a fraud specialist, who convinced them to withdraw $300,000 from their investment portfolio at their financial institution, and advised them to purchase gold coins so that they could prevent impending theft. The scammer convinced the client not to speak to family or other advisors about the issue, highlighting security concerns. Once the client withdrew the funds and purchased the coins, the scammer’s accomplices retrieved the coins and assured the client that a federal marshal would bring a check to reimburse them. When no one showed up to do so, the client contacted the local authorities. After a report was made, the FBI conducted an investigation and informed the client that there was little to no prospect of recovery.

It was clear that the criteria had been met in this case, since (1) the loss was a result of a fraudulent scheme, (2) the motive was to safeguard the investments from theft, and (3) there was no reasonable prospect of recovery. However, the client’s investments included both traditional and Roth IRAs, and the memo did not address the issue of basis in a Roth. The Treasury Regulations state that, in general, basis in distributions from Roth IRAs are the fair market value of property at the time of distribution, regardless of whether they are qualified distributions. Treas. Reg. 1.408A-6, Q16 and A-16.

We assisted the client in preparing a disclosure statement to file with their tax return for the year. After filing, we were notified by the client that the IRS issued the full income tax refund that was calculated based on the full amount of the theft loss deduction.

CASE 2: Check Fraud Scam

Another client at the tax clinic was contacted by a Microsoft security expert (who turned out to be an impersonator) when they first encountered login issues on their new laptop. The client was soon convinced by the imposter that their IRA with their investment management company was compromised—that several fraudulent transactions had been initiated from the client’s IRA but that the client could reverse such transactions. The imposter put them in contact with a purported agent of their investment management company’s “Fraud Prevention Department,” who was also an imposter.

The two scammers were able to isolate the client from contacting others (such as their spouse, family, and bank) by convincing them  that their laptop and their phone were not secure and that any such attempts could result in them losing all their money and/or the perpetrators getting away with the fraudulent transactions. The fake investment management agent shared that the client’s current IRA advisor was likely the source of the fraud, that he had likely tried to initiate other transactions to a bank in a foreign country from their IRA.

The client was instructed to withdraw the entirety of their IRA balance and send blank checks to a supposed agent of the Social Security Administration, who would reinvest such amounts to a different IRA with the same investment management company. The client followed through and deposited their IRA distributions to their personal bank account and made checks to the SSA agent, which the client mailed to the agent.

The client was soon informed of withdrawals made to their bank account in the sum of over $1.5 million and the fake investment management agent assured the client that the money would be reinvested. However, when the client finally made inquiries to the investment management company (using the official customer service number on the official company website), the client was informed that they had no accounts with the investment management company (new or old). The client took precautionary measures to safeguard from further fraud and contacted the authorities (including the Secret Service, United States Postal Inspection Service, and the County Sheriff’s Office).

Similar to Case 1, this taxpayer also meets the requirements set forth in the IRS CCM: (1) the client sustained a loss due to theft perpetrated by imposters; (2) the theft loss was incurred by the client in a transaction entered into for profit, as their sole intention in withdrawing funds from their IRA was for reinvestment purposes; and (3) as both federal and local authorities attest that they will likely be unsuccessful in catching the perpetrators, there is no chance of recovery in the current year, if ever. Lastly, the client’s basis in the distributions is limited to their adjusted basis in the property stolen. The adjusted basis in cash, which is the property stolen in this case, would be the nominal value of such moneys subject to theft. Thus, the deduction amount here would equal the amount considered and included in their income for federal tax purposes, that is, the entire amount of over $1.5 million. See, CCM, IRC §165(b) and Treas. Reg. §1.165-1(c).

We prepared a disclosure statement to be included with the client’s tax filing for the year. After the filing, the client notified us that the IRS had issued a full refund equal to the amount that the client claimed in their filing.

Conclusion

As technology and artificial intelligence improve, scammers will find new and inventive methods of defrauding people and committing financial crimes. While the first line of defense against such scams from affecting people on a large scale includes congressional action, public awareness, and individual responsibility to secure one’s finances, it is also important to provide recourse for victims of financial crimes as well as relief from additional unwarranted burdens. In the absence of congressional action to provide such relief for taxpayers, the new IRS Chief Counsel Memorandum provides a small safe harbor for certain victims of theft and illegal financial taking.

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MORE ONLINE > For more information about the University of Washington Federal Tax Clinic, visit www.law.uw.edu/academics/experiential-learning/clinics/federal-tax.

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