I recently went to a meeting of CPAs who were sharing their experiences after tax season, 2022. The subject came up of clients who suffered financial losses because they fell for scams.
In one case, a client made a big withdrawal from an IRA and invested and lost the funds in a bitcoin scam.
According to the Federal Trade Commission, consumers lost more than $5.8 billion to fraud during 2021, a 70% increase over the prior year. Almost 2.8 million people filed a fraud report.
Most of the frauds related to selling fake health products and using stolen data to file for unemployment and other benefits in victims’ names. Imposter scams were the most prevalent form of fraud in 2021. The typical victim lost $1,000.
Investment frauds were more costly, the average loss was $3,000 per victim in 2021.
The majority of fraud victims were young Americans, but those over age 70 reported losing more money.
(Consumers lost $5.8 billion to fraud last year – up 70% over 2020, CNBC, February 22, 2022. Consumers lost $5.8 billion to fraud last year up 70% over 2020 | User Walls)
The tax consequences of fraud on the victims are complex and usually aren’t good news.
A provision of the Tax Cuts and Jobs Act of 2017 eliminates the deduction for personal casualty and theft losses for taxable years 2018 through 2025. (Internal Revenue Code Section 165(h)(5).)
There is an exception for transactions entered into for profit and not connected with a trade or business, such as an investment in a Ponzi scheme. (Internal Revenue Code Section 165(c)(2).) These losses are miscellaneous itemized deductions. They aren’t subject to $100 per casualty reduction or 10% of AGI reduction. Since the standard deduction has also been increased by the Tax Cuts and Jobs Act of 2017 to $25,100 for 2021 for married persons filing a joint return and $12,550 for single persons who aren’t blind or age 65 or older and itemized deductions for state taxes have been capped at $10,000, many taxpayers won’t get a tax benefit from claiming the deduction, even if they otherwise qualify to claim it, because the standard deduction will be higher than their itemized deductions.
The loss is claimed on IRS Form 4684, Section B.
If a taxpayer makes an investment, such as in bitcoin, that falls in value, it doesn’t qualify as a fraud loss. The loss might qualify as a capital loss, which is limited each tax year to capital gains plus $3,000.
According to Internal Revenue Code Section 165(e), theft losses are treated as sustained during the taxable year in which the taxpayer discovers the loss. According to the IRS, the loss can’t be deducted until the taxpayer can establish that there isn’t a reasonable prospect of recovery. Whether a reasonable prospect of recovery exists is a question of fact to be determined upon examination of all of the facts and circumstances. In order to establish whether a loss can be recovered, the taxpayer should file a lawsuit and then show a settlement, adjudication or abandonment of a claim. The resolution could happen years after the loss occurred or was discovered. That’s especially a problem when the taxpayer got the funds from a taxable source, like from an IRA or by selling a taxable investment. In that case, the deduction can’t be matched with the income, or the taxpayer’s income could be much lower for the year when the taxpayer can establish there isn’t a reasonable prospect of recovery, reducing or eliminating the tax benefit from claiming the loss. (See Revenue Ruling 2009-9.)
Establishing that a loss was from a theft or fraud and that the transaction was entered into for profit also might be hard to document and prove.
Summarized, getting a tax benefit for a loss due to fraud or theft is not a “slam dunk.” It’s not easy to establish the loss was from a theft or fraud, the amount of the loss, and what tax year the loss is tax deductible. The increased standard deduction and reduced itemized deductions, including eliminating the itemized deduction for most personal casualty and theft losses for taxable years 2018 – 2025, enacted as part of the Tax Cuts and Jobs Act of 2017 are additional hurdles to getting a tax deduction for a fraud or theft loss. This is not a do-it-yourself project. If you have a significant fraud or theft loss relating to a transaction entered into for profit, seek help from a qualified tax professional.