When Tax Scams Hit Home: What to Know About Theft Loss Deductions

By Samuel Handwerger, CPA, Faculty Advisor for TerpTax

TerpTax, the pro bono tax preparation group at the University of Maryland’s Robert H. Smith School of Business, served 1,700-plus clients this past tax season. Although I did not meet with every one of them, I did meet many. And with all due respect for the wonderful people I encountered, after a while, the faces and their tax profiles start to blend together. 

Not so when I met Sarah (not her real name), who walked into our offices rather sheepishly and presented a case that tears your heart out to hear it. “They took everything,” she whispered. “…$350,000, representing everything I had... gone. Gone." 

Sarah had fallen victim to what appeared to be a legitimate investment opportunity. The scammers were sophisticated. They had professional websites, testimonials, and even sent her small “returns” at first to build trust. By the time she realized it was all fake, they had vanished with her life savings. “Can I at least get a tax break for this nightmare?" she asked, her voice barely audible. 

The answer, thankfully for Sarah, was yes. But it's not that simple for everyone. The IRS clarified these rules in January 2025, with more guidance in a March 2025 IRS Chief Counsel memorandum that addresses various fraud scenarios. I want to share what you need to know if you or someone you care about has been scammed. 

What exactly counts as a "theft loss" to the IRS? For a loss to be deductible, a few key things need to happen: 

• Someone must have illegally taken your property (as defined by your state's laws).
• You discovered the theft this year and have no reasonable chance of getting your money back.
• The theft happened during a transaction where, and this is the crucial point, you were trying to make money.

All these ingredients put the loss into the category of an investment scam, which is the key point to a tax deduction that ultimately reduces some of your tax. And while it doesn't recover your loss in full, only to the extent of your tax savings afforded because of the deduction, at least it is something. 

It All Comes Down to Profit Motive 

The IRS Chief Counsel has made it clear: Your intention when transferring the money makes all the difference. 

As Sarah explained her situation to me, I could see that she clearly qualified. The scammer stole from her investment account, making it deductible under tax code section 165(c)(2). In Sarah's case, she could deduct her losses because she clearly thought she was investing for profit. This classification matters tremendously as “investment losses” (section 165(c)(2)) can still be deducted post-2017 tax law changes, while personal theft losses (section 165(c)(3)) generally cannot. 

Differentiating Personal Losses from Investment Losses 

Thanks to the 2017 tax law changes (Tax Cuts and Jobs Act), personal theft losses generally aren't deductible until at least 2026 (unless they're related to a federally declared disaster). Now consider if you fell victim to: 

• A romance scam where you sent money to someone you met online
• A “your child is in trouble” emergency scam
• Someone impersonating the IRS or police to extort money
• A terrifying “kidnapping” scam using AI to clone a loved one’s voice

With the tragic losses you are, unfortunately, out of luck tax-wise— even though these scams can be just as devastating financially and emotionally. The IRS Chief Counsel memorandum specifically addresses these scenarios, confirming that victims in these situations must recognize income if they withdrew from retirement accounts but get no offsetting deduction. That’s a horrible loss and tax result all piled into one. 

What about Ponzi schemes? Ponzi schemes have their own special rules. To qualify for this deduction: 

• The scammer must be criminally charged
• It must be a classic Ponzi structure (new investor money paying old investors)
• You need to claim the deduction in the year you discovered fraud

If you qualify, you can deduct 75% of your losses if you're pursuing recovery from other parties, or 95% if you're not. However, the IRS memorandum clarifies that most online fraud victims won't qualify for this safe harbor if the fraudster remains unknown, unidentified, or uncharged with a state or federal crime. 

If you think you might qualify for a theft “investment” style loss deduction: (1) check eligibility first (save yourself the headache); (2) calculate your loss amount carefully; (3) gather all evidence - transaction records, police reports, communications; (4) make sure there's truly no chance of recovery; and (5) file IRS Form 4684, Section B (for business/investment property).

Consider working on this with a tax expert. The rules are complex, and the IRS scrutinizes these deductions closely. Even the IRS Chief Counsel memorandum itself cautions that its conclusions are “dependent on the taxpayer's specific facts,” and it's not binding precedent. As I told Sarah when she left my office with at least a small glimmer of hope: "We can't undo what happened, but we can make sure you get every tax benefit you're entitled to during this difficult time."

Samuel Handwerger is a full-time lecturer in the accounting and information assurance department at the University of Maryland’s Robert H. Smith School of Business. He is co-director of the Financial Wellness Center and faculty advisor to a pair of student-volunteer organizations: Justice for Fraud Victims and TerpTax, the nonprofit organization affiliated with UMD that provides free tax preparation services for low to mid-income individuals in the University of Maryland, College Park community.