How Tax Law Treats Scam Losses

Under the tax code, losses from scams are generally treated as theft losses, not casualty losses. While both are addressed under Internal Revenue Code Section 165, they are subject to different rules. 

Since 2018, the Tax Cuts and Jobs Act has significantly restricted personal theft loss deductions. As a general rule, theft losses involving personal-use property are deductible only if they result from a federally declared disaster. Most scams do not meet this standard. 

However, the law still allows a potential exception. 

The Key Exception: Transactions Entered Into for Profit 

Even though most personal theft losses are no longer deductible, the tax code preserves an important avenue for relief. 

Losses incurred in a transaction entered into for profit may still be deductible, even if no disaster declaration applies. 

This exception falls under Internal Revenue Code Section 165(c)(2) and can apply when a taxpayer is scammed while attempting to invest or earn income. 

The IRS distinguishes between money lost due to personal circumstances, such as romance scams or ransom scams, and money lost while pursuing a legitimate profit-making objective, even if the investment turned out to be fraudulent. 

What Must Be True for a Scam Loss to Be Deductible? 

To qualify under the profit-motive exception, several conditions generally must be met. 

1. There Must Be a Clear Profit Motive 

The taxpayer must have entered the transaction with a genuine intention to earn income or achieve financial gain. This intent must be objective and supportable with documentation, not simply a desire to protect or move money. 

Examples that may support a profit motive include: 

• Transfers made to purchase securities or other investments 

• Funds sent to what was believed to be an income-producing account 

• Participation in an apparent investment opportunity 

Personal motivations, such as helping someone, responding to emotional pressure, or acting out of fear, do not qualify. 

2. The Loss Must Result From Theft Under State Law 

The IRS looks to whether the facts support a theft under applicable state law, including fraud or false pretenses. 

3. There Must Be No Reasonable Prospect of Recovery 

A loss is deductible only when it becomes clear that recovery is unlikely. While overseas transfers often make recovery difficult, the IRS evaluates this based on the full set of facts, including bank clawback efforts, insurance claims, or legal remedies. 

4. Documentation Matters 

Taxpayers should retain: 

• Communications with the scammer 

• Records of wire transfers or withdrawals 

• Evidence showing the transaction was intended to produce income 

• Confirmation that recovery efforts were unsuccessful 

Recent IRS Guidance on Scam Losses 

In March 2025, the IRS issued a Chief Counsel Memorandum analyzing several scam scenarios. While this type of guidance does not create binding law, it provides insight into how the IRS evaluates these cases. 

The memorandum confirms that investment-related scams may qualify for a deduction when the taxpayer intended to invest for profit and the loss meets the theft and recovery standards discussed above. 

By contrast, scams rooted in personal relationships or emotional manipulation generally do not qualify for a deduction under current law. 

Retirement Accounts: An Added Tax Complication 

Many scam victims fund transfers using retirement accounts, which can trigger additional tax consequences. 

Traditional IRAs and Tax-Deferred Plans 

If funds are withdrawn from a traditional IRA or retirement plan due to a scam: 

• The distribution is generally taxable income. 

• If the taxpayer is under age 59½, a 10 percent early withdrawal penalty may apply. 

• There is no special exception for scam-related distributions. 

In limited circumstances, a taxpayer may avoid tax by completing a 60-day rollover using other available funds. Strict rules apply, including limits on how often rollovers can occur. 

Roth IRAs and Roth Plans 

Roth contributions, but not earnings, can generally be withdrawn tax-free. However: 

• Early withdrawal of earnings may be taxable and penalized. 

• The five-year holding rule and other qualifications still apply. 

Examples That Illustrate the Difference 

Example 1: Investment Impersonator Scam 

A taxpayer is told their accounts are compromised and is instructed to move funds into a secure investment account. Believing the funds will be invested for profit, the taxpayer transfers money from both IRA and non-IRA accounts. The account is fraudulent, and the funds are irretrievable. 

Result: 

Because the taxpayer believed they were investing in an income-producing account, the loss may qualify as a theft loss incurred in a transaction entered into for profit, assuming other requirements are met. 

The theft loss may be deductible if properly substantiated. IRA distributions remain taxable and potentially subject to early withdrawal penalties. Non-IRA losses may be deductible depending on the facts. 

Example 2: Romance Scam 

A taxpayer sends money to someone they believe is a romantic partner to help with a personal emergency. Funds come from IRA and non-IRA accounts and are sent overseas. 

Result: 

The loss is personal in nature and lacks a profit motive. It is treated as a personal theft loss, which is generally not deductible under current law. Taxation of the IRA distribution still applies. 

Example 3: Kidnapping Scam 

A taxpayer is told a grandchild has been kidnapped and sends ransom money under duress. The funds are taken from retirement and non-retirement accounts. 

Result: 

Despite the fraud and emotional trauma involved, the transaction was not entered into for profit. The loss is not deductible, though the tax consequences of the retirement distributions remain. 

Practical Takeaways 

Intent matters. The IRS focuses heavily on why the funds were transferred. 

• Most personal scams are not deductible, no matter how compelling the circumstances. 

• Investment-related scams may qualify, but only with strong documentation. 

• Retirement account distributions create separate tax consequences, even when the funds are stolen. 

A Final Word 

If you receive an unsolicited message, investment opportunity, or urgent request involving money, pause before acting. Consulting a trusted advisor before transferring funds can prevent irreversible harm. 

If you or a family member has already been affected by a scam, especially one involving investments or retirement accounts, seek professional guidance promptly. Early action can help clarify options, document losses, and reduce further financial damage.