Can a Taxpayer Deduct a Theft Loss?

The specific facts and circumstances are key in the determination

There have been many unfortunate stories this tax season of clients who have been scammed and had money or cryptocurrency stolen. Their tax professionals, understandably so, want to provide relief by deducting the theft loss under §165.

However, thanks to changes made by the Tax Cuts and Jobs Act (TCJA), it is now much more challenging to deduct many theft losses, and the determination can be quite complex. The tax professional must know the detailed facts and circumstances of the theft to apply the law correctly.

While a tax professional may feel terrible for the taxpayer's hardship, there remains a professional responsibility under Circular 230 §10.34 only to take positions on a tax return that have a reasonable basis in the law. Treas. Reg. §1.6662-3(b)(3) states:

The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim. If a return position is reasonably based on one or more of the authorities set forth in §1.6662-4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments), the return position will generally satisfy the reasonable basis standard…

Theft Loss Defined

Treasury regulations provide specific rules related to theft losses. A theft includes but is not limited to larceny, embezzlement, and robbery. A taxpayer claiming a theft loss must prove that the loss resulted from a taking of property that was illegal under the law of the jurisdiction in which it occurred and was done with criminal intent. See Treas. Reg. §1.165-8(d) and Rev. Rul. 72-112.

The deduction is sustained in the tax year the taxpayer discovers the loss. However, if in the year of discovery, there exists a reimbursement claim for which there is a reasonable prospect of recovery, the loss is not allowed until it can be ascertained with reasonable certainty whether or not such reimbursement will be received. See Treas. Reg. §1.165-8(a)(2) and Treas. Reg. §1.165-1(d).

The theft loss amount is the lesser of the decrease in the property's fair market value (FMV) or its adjusted basis; the FMV after the theft is deemed $0. See Treas. Reg. §1.165-8(c) and Treas. Reg. §1.165-7(b).

Three Types of Theft Losses

Under §165(c), a theft loss can fall into one of three categories:

1. Losses incurred in a trade or business (§165(c)(1)),

2. Losses incurred in any transaction entered into for profit (§165(c)(2)), or

3. All other losses incurred, commonly referred to as personal casualty losses (§165(c)(3)).

Trade or business loss. In a §162 trade or business, the individual is involved in an activity with continuity and regularity, and the primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify. See Comm. v. Groetzinger, 480 U.S. 23 (1987).

The loss is calculated in Section B of Form 4684, Casualties and Thefts, and it is an above-the-line ordinary loss.

Transaction entered into for profit loss. In a §212 activity engaged in for profit, the taxpayer's primary objective in engaging in the activity is to realize an economic profit independent of tax savings. However, it lacks the continuity and regularity required to be a trade or business activity. See Surloff v. Comm., 81 T.C. 210 (1983). Treas. Reg. §1.183-2 contains nine factors to consider when determining if an activity is in engaged for profit.

Many investment-related thefts could be considered §165(c)(2) losses depending on the specific facts and circumstances. In Rev. Rul. 2009-9, the IRS held the following:

In opening an investment account with B, A entered into a transaction for profit. A's theft loss therefore is deductible under § 165(c)(2)…

The loss is calculated in Section B of Form 4684, Casualties and Thefts, and it is a miscellaneous itemized deduction on Schedule A (not subject to the 2% of adjusted gross income (AGI) floor).

Personal casualty loss. All other theft losses fall into this category, and post-TCJA, they can only be deducted if they are attributable to a federally declared disaster or to the extent of personal casualty gains per §165(h)(5).

In addition, any allowed theft loss under this provision must be reduced by $100 and 10% of the taxpayer’s AGI per §165(h)(1) and §165(h)(2).

The loss is calculated in Section A of Form 4684, Casualties and Thefts, and it is a miscellaneous itemized deduction on Schedule A (not subject to the 2% of AGI floor).

If the theft loss is a qualified disaster loss, it is only reduced by $500 and can be added to the taxpayer’s standard deduction. For example, under §2 of the Federal Disaster Tax Relief Act of 2023, almost all disasters declared between 2021 through 2024 allow qualified disaster loss treatment.

Taxpayer’s Motive is Essential

In Chief Counsel Advice 202511015, the IRS analyzed five different thefts and how §165 applied to those losses. This analysis is key to properly categorizing a theft loss:

For taxpayers who authorized distributions and transfers to new accounts or directly to Scammer A, we look to their motive in doing so to determine the character of the transactions. Taxpayers who establish that their motive was to transfer their investment funds from existing investment accounts to new investment accounts, i.e., to safeguard existing investments or to engage in new investments, had a profit motive when authorizing the distributions and transfers. These actions qualify as a transaction entered into for profit under §165(c)(2), to which the theft loss relates, regardless of any intermediate steps taken at the direction of Scammer A. For taxpayers who were motivated to transfer funds to Scammer A as part of a non-investment scam, i.e., the romance scam and kidnapping scam, there is no profit motive for the transaction, and the loss is a disallowed personal casualty loss. For taxpayers who did not authorize any distribution or transfer, the loss does not result from the actions of the taxpayer so that the relevant transaction for determining the character of the loss is the original investment and the motive of the taxpayer at that time.

Ponzi Safe Harbor Confusion

In the Bernie Madoff era, the IRS released Rev. Proc. 2009-20 so that certain victims of Ponzi schemes could have safe harbor protection to claim a §162(c)(2) loss for a transaction entered into for profit. If a taxpayer’s situation met the specific safe harbor requirements, the IRS would not challenge the taxpayer’s loss treatment. This does not mean any victim of a financial-related theft can deduct their loss using Rev. Proc. 2009-20.

There are tax professionals inappropriately using Rev. Proc. 2009-20 to claim losses, especially with respect to digital assets. Tax professionals must do proper due diligence; as the IRS stated in Chief Counsel Advice 202511015:

The Ponzi safe harbor is available only to taxpayers with an allowable theft loss who otherwise meet the requirements set forth in Rev. Proc. 2009-20.

In the five theft loss examples the IRS outlined in Chief Counsel Advice 202511015, the IRS opined that none of them qualified for the Rev. Proc. 2009-20 safe harbor.

If a taxpayer does not meet the Rev. Proc. 2009-20 safe harbor requirements that does not mean they cannot claim a loss under §165(c)(2); it simply means they do not get the audit protection afforded by the safe harbor. The taxpayer must show that they are entitled to a §165(c)(2) loss based on their facts and circumstances.

If a taxpayer does qualify to use the Rev. Proc. 2009-20 safe harbor, the loss is calculated in Section C of Form 4684, Casualties and Thefts.

Theft Within a Retirement Account

If the theft caused a reduction in value within a tax-deferred retirement account, but there was no distribution of the stolen amount, the loss is generally non-deductible. In INFO 2009-0154, the IRS said:

If taxpayers have basis in a tax-favored retirement plan or IRA (for example, because they made after-tax contributions to IRA), they can take a miscellaneous itemized deduction to the extent they have unrecovered basis after their entire interest in plan or IRA is distributed. For an IRA, the aggregate amount in all of the taxpayer's IRA's must have been distributed. If taxpayers have no basis in the retirement plan or IRA (for example, because they claimed a deduction for IRA contributions), they cannot take a deduction for the economic loss in the plan or IRA.

If the funds were distributed and included in gross income, the taxpayer has basis in the funds to claim a theft loss deduction. In Chief Counsel Advice 202511015, the IRS used the following analysis:

The amount of the loss allowable as a deduction is limited to the taxpayer’s basis in the property. In this case, Taxpayer 1 is liable for Federal income tax on the IRA account distribution and will recognize gain or loss from the disposition of assets in the non-IRA account, giving Taxpayer 1 basis in all of the stolen funds for purposes of calculating the amount of the deductible theft loss.

Post-Publication Updates

March 15, 2025:This article was revised to include content from Chief Counsel Advice 202511015.

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