Reporting a Theft Loss under Section 165(c)(2) of the Internal Revenue Code

Taxpayers are encountering an increasing number of sophisticated scams and fraudulent  activity from a variety of bad actors. Unfortunately, victims of scams are often hit with a double  whammy of not only the loss of their savings but also a tax bill on withdrawals from retirement  accounts and the sale of assets. 

The Tax Cuts & Jobs Act of 2017 established limitations on the deductibility of personal  theft and casualty losses and narrowed the options available to taxpayers. More recently, the IRS  provided additional guidance on whether scam victims could report a theft loss under § 165 of the  Internal Revenue Code.  

Navigating IRC § 165(c)(2) 

Many individual taxpayers that were the victim of a theft or personal casualty loss found  themselves stuck unless the loss occurred in a federal declared disaster area pursuant to §  165(h)(5). IRC § 165(c)(2) sets forth a key distinction. This provision established a path for  deductions connected to losses arising from transactions entered into for profit, though not  connected with a trade or business. The recent IRS Chief Counsel Memorandum has further  clarified how this rule applies to modern financial crimes. See IRS Chief Counsel Memorandum  202511015 (March 14, 2025). 

To report a theft loss under § 165(c)(2), a taxpayer must meet three basic requirements: 

• (1) A transaction(s) entered into for profit. The taxpayer’s primary motive for  entering into the transaction(s) was to make a profit.
  • The IRS guidance has clarified that victims of compromised account scams,  pig butchering scams, and phishing scams meet the profit motive  requirement.
  • On the other hand, the IRS guidance clarified that victims of romance and  kidnapping scams likely do not meet the profit motive requirement.
• (2) Theft under state law. The taxpayer must be a victim of conduct that constitutes  theft or embezzlement under the applicable state law. 
• (3) No reasonable prospect of recovery. The taxpayer must have no reasonable  prospect of recovering their funds through a criminal investigation, insurance  claim, civil litigation, restitution, or other means. 

Reporting a Theft Loss

Generally, a qualifying theft loss is reportable in the year that the theft is discovered, and  in which it is determined that there is no reasonable prospect of recovery. A taxpayer reports their  loss using Form 4684 – Casualties and Thefts. A taxpayer’s maximum allowable deduction is  limited to the taxpayer’s adjusted based in the lost property or invested funds.

The Importance of Supporting Documentation 

Claims of theft loss under § 165(c)(2) are subject to a thorough review by the IRS. A  taxpayer bears the burden of proof in substantiating their claim. Even an otherwise valid claim  may be denied if the taxpayer possesses insufficient documentation. A prudent taxpayer should  document the following: 

• Investment intent. Correspondence, marketing materials, notes, photos, and other  documentation showing that the taxpayer intended to invest their funds for a profit. 
• Financial Records. Banking and account statements, wire transfer confirmations,  cryptocurrency transfers, and other documentation detailing the transfer of funds. 
• Police Reports. Documentation reporting the scam to the authorities such as the FBI, FTC,  and local police. 
• Written Legal Assessment. A written legal assessment from tax counsel analyzing the facts  and circumstances of the loss and the application of § 165(c)(2) to the taxpayer’s  circumstances. 

Conclusion 

Being the victim of a scam while navigating the provisions of the Internal Revenue Code  is complex. A taxpayer’s particular facts and circumstances will determine whether relief pursuant  to § 165(c)(2) is available. 

This article is for informational purposes only and should not be considered legal advice.  If you have additional questions, schedule a consultation with the Law Office of Jonathan D.  Mishkin, P.C.