NTA Blog: IRS Chief Counsel Advice on Theft Loss Deductions for Scam Victims and What It Means for Taxpayers

On March 14, 2025, the IRS Office of Chief Counsel (Chief Counsel) released advice memorandum number 202511015, addressing the deductibility of theft losses under IRC § 165 for scam victims. The memo offers important clarification on when and how taxpayers may claim a theft loss deduction. It also exposes gaps in the current law that leave many taxpayers without meaningful relief.

As the National Taxpayer Advocate, I have previously recommended reforms to prevent scam victims from being penalized by the tax system. Chief Counsel’s memo shows that more victims than perhaps previously thought might qualify for the theft loss deduction, but it also illustrates how much work remains to help all taxpayers who find themselves victims of fraud.

Theft Loss Deductions Then and Now

Section 165(c) of the Internal Revenue Code allows taxpayers to deduct losses sustained during the taxable year that are not reimbursed by insurance or other compensation. Historically, this provision has been a help to individuals suffering financial losses from theft, fraud, or other criminal conduct. Before the Tax Cuts and Jobs Act (TCJA) of 2017, theft losses – whether personal or investment-related – were subject to certain limitations based on adjusted gross income thresholds.

The TCJA significantly restricted this deduction. For tax years 2018 through 2025, personal casualty and theft losses are deductible only if they arise from a federally declared disaster. As a result, most scam victims – such as those defrauded through romance scams, imposter fraud, or other non-investment schemes – have been ineligible to deduct their losses. Only victims who entered into a transaction for profit (e.g., an investment scam) have been able to claim the deduction.

Unless Congress extends the limitation, the TCJA restriction will expire at the end of 2025. If Congress allows the provision to sunset, theft loss deductions may again be available to most taxpayers.

What the Memo Says

The Chief Counsel memo affirms that taxpayers who are victims of scams may claim a theft loss deduction under IRC § 165, but only if their situation meets specific conditions:

• The loss must result from criminal conduct classified as theft under applicable state law;
• The taxpayer must have no reasonable prospect of recovering the stolen funds; and
• The loss must arise from a transaction entered into for profit.

The memo clarifies that a taxpayer can establish a profit motive not only through a traditional investment scam but also in situations where a scammer misleads a taxpayer into moving money under the false belief that they are protecting it. However, those who lose money through personal scams – such as romance scams or false kidnapping schemes – do not qualify for the deduction under current law due to the TCJA’s restrictions on personal casualty and theft losses.

Issues the Memo Highlights

In my 2024 Annual Report to Congress, I identified tax-related scams as one of the most serious problems facing taxpayers. Under current law, scam victims suffer complex tax issues on top of their devastating financial losses.

The Chief Counsel memo correctly acknowledges that scam victims suffer real financial harm. It also reinforces that taxpayers may deduct losses in the year they discover the scam as long as they have no reasonable expectation of recovery. Lastly, the memo recognizes that taxpayers who are tricked into withdrawing funds from a tax-deferred account may face significant tax consequences, including an additional tax on early withdrawals, despite having received no benefit from the withdrawn funds.

This last point is particularly important. Although it does not state so specifically, the memo shows that even under an interpretation that allows some theft loss deductions, taxpayers still require additional legislative remedies to prevent scam victims from being taxed on money they never truly received.

What Scam Victims Still Need

The Chief Counsel memo offers an interpretation of the current IRC § 165 that assists some scam victims, but it also underscores remaining legislative gaps. Legislative Recommendation #54 in my 2025 Purple Book proposes solutions to provide comprehensive relief to scam victims. Here are some of the solutions:

Restoring Theft Loss Deductions for All Victims

Congress should allow the TCJA restriction to expire at the end of this year. Scam victims shouldn’t be treated differently based on whether the scam involved a false investment or a false personal relationship. Many victims are ordinary taxpayers misled by increasingly sophisticated frauds. Restoring the broader theft loss deduction would allow all victims a chance to deduct their losses. Congress should also consider making this change retroactive to cover theft losses sustained between 2018 and 2025.

Allowing Theft Loss Deductions in the Year of Income Inclusion

The current version of IRC § 165(e) requires taxpayers to deduct a theft loss in the year they discover the scam, not the year they lost the money. This creates a problem when the taxpayer reported the income from the tax-deferred withdrawal in a prior year.

For example, consider a taxpayer who normally earns $50,000 a year. In Year One, they are scammed into withdrawing $100,000 from their tax-deferred 401(k), increasing their taxable income that year to $150,000. They discover the scam in Year Three, when their total income is back to $50,000. As a result, they may not be able to deduct the entire theft loss against their Year Three income, which does not include the income from the 401(k) distribution.

This mismatch is inherently unfair to taxpayers. Congress should revise the law to allow taxpayers to amend the original tax return to claim the loss deduction in the same year they reported the additional income.

Waiving Early Withdrawal Penalties for Scam Victims

Withdrawals from deferred accounts before age 59½ generally incur a ten percent additional tax under IRC § 72(t). Although there are several exceptions, scams and theft losses are not among them.

Congress should exempt scam victims from this additional tax when the early withdrawal was made under fraudulent pretenses. Victims who acted under duress and deceit should not face further financial penalties from their tax system. Penalizing them for falling victim to fraud only compounds their financial hardship. Eliminating this additional ten percent tax for early withdrawal would help prevent the tax code from compounding the harm caused by scammers.

Extending the Statute of Limitations for Refund Claims

Under current law, if a victim discovers a scam after the three-year statute of limitations for a refund claim has passed, they cannot amend their return to claim a theft loss deduction. This rule unfairly penalizes taxpayers who are unaware they’ve been defrauded until it’s too late. Extending the limitations period would ensure that victims of delayed-discovery scams have a fair opportunity to claim the relief they deserve.

Conclusion

The Chief Counsel memo brings welcome clarification, but many scam victims remain ineligible for relief under current law. Taxpayers have the right to a fair and just tax system. As the National Taxpayer Advocate, I will continue recommending reforms that ensure fairness for taxpayers who fall victim to scams. I urge Congress to adopt the recommendations outlined in the 2025 Purple Book to provide meaningful relief to all scam victims and restore fairness to the tax code.

Resources

• 2024 Most Serious Problem #5, Tax-Related Scams: More Taxpayers Are Falling Victim to Tax-Related Scams
• 2025 Purple Book Legislative Recommendation #54, Allow the Limitation on Theft Loss Deductions in the Tax Cuts and Jobs Act to Expire So Scam Victims Are Not Taxed on Amounts Stolen From Them
• Chief Counsel Memo Number 202511015
• Safe Harbor for Ponzi Schemes: Rul. 2009-9, 2009-14 I.R.B 735; Rev. Proc. 2009-20, 2009-14 I.R.B. 749, as modified by Rev. Proc. 2011-58, 2011-50 I.R.B 849

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