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Jeremy Wells: Welcome back to Tax in Action. I am Jeremy Wells here with part two of the series on casualties, thefts and involuntary conversions. This episode we're going to talk about theft losses. Theft losses. Uh, while I don't recommend them, uh, they're not fun to go through, but the topic [00:00:30] itself, I think is pretty interesting, especially over the last few years, we've had some developments that have really sort of sparked a, uh, new interest in this concept of theft losses. And a lot of that is driven by digital assets, especially cryptocurrency. So, uh, I'm not by any means an expert on cryptocurrency. I have a few colleagues who are, uh, but in terms of the tax [00:01:00] implications of what can happen with some of these digital currencies, some of the scams that you can get involved with, with those with some of the schemes that fraudsters can engage in. There's some renewed interest in this concept of theft loss, especially when we talk about when those theft losses are actually deductible under the Tax Cuts and Jobs Act. So let's jump right into it. One of the main issues here when it comes to theft losses that we're going [00:01:30] to talk about, is the difference between personal losses and investment losses or losses of income producing assets. This came up talking about casualty losses in the previous episode. It gets really important when we're talking about theft losses. This is one of the most misunderstood areas in tax practice for both practitioners as well as individuals and [00:02:00] taxpayers taxpayers.
Jeremy Wells: The ones I've worked with that have been through situations like this, especially with casualty losses, those that have worked with, uh, living in Florida, for example. Uh, there's just a lot of confusion among taxpayers about when these events cause some sort of taxable event, when they're deductible, how much that deduction is. And that's just as true for theft losses as it is for casualty losses. So in this episode, I'm going to clarify [00:02:30] when a loss qualifies as a theft loss, how to determine the timing and the amount of that theft loss. And then what's change in the area of scams and fraud over the last several years? The timing of a theft loss is especially important there. That is, a is a particular part of this that's really important to understand. So we're going to talk about what a theft loss is within tax law. We're going to look at what the requirements are coming out of, [00:03:00] uh, Internal Revenue Code section 165 for deducting those theft losses, along with some other guidance that we have from IRS, including Treasury regulations and a couple of revenue rulings and revenue procedures. So we get really into the weeds of the guidance as well as some court cases. I'm going to wrap up this episode with what I think is a pretty interesting court case, uh, along with, uh, some lessons we can learn from that.
Jeremy Wells: That's really helpful in all aspects [00:03:30] of tax practice. But, uh, really excited to talk about that. We're also going to look at how we determine the timing of the deduction for a theft loss, as well as how to calculate that. And then where we're going to report that on the tax return, going to look at some examples that IRS discusses uh, through a uh chief counsel advice memorandum of different types of scams and what actually makes them [00:04:00] a deductible type of scam, as opposed to some that are not. And those differences can be very fine. They can be very nuanced. And as practitioners, when we're talking with taxpayers who might have been through some of these kinds of scams or schemes, it can be a very fine line between whether that event was actually a deductible theft loss or not. And this is especially true when we start talking about bringing digital assets [00:04:30] and cryptocurrencies into the fold here. So let's talk about defining a theft loss. Again. This is a bit of a review from the prior episode on casualty losses. There are three types of losses under IRC section 165 losses that are incurred in a trade or business. Those are generally always deductible with some limitations, but those are beyond the scope of [00:05:00] discussing section 165. We might be talking about at risk limitations, passive loss limitations, those sorts of things. But in general, when we're talking about a casualty or theft loss arising in a trade or business, those are going to be deductible.
Jeremy Wells: Also, losses incurred in any transaction entered into for profit, even if it's not connected with a trade or business. We talked about briefly about that with casualty losses, but that's going to be even more important here when we're talking about theft losses, [00:05:30] because we're going to bring into the discussion here with theft losses as to whether the event that gave rise to the theft was entered into by that taxpayer as a personal investment or entered into for profit, and then finally, losses of property not connected with a trade or business or a transaction entered into a profit, or what we would just call personal losses. When those come about from casualties [00:06:00] or thefts. Now, of course, again, a reminder the Tax Cuts and Jobs Act of 2017 eliminates the deduction for personal casualty and theft losses for tax years 2018 through 2025. So as I'm recording, we are in the final year of this limitation. When we get past 2025, it's possible that some of these losses do come back as potentially deductible. Now [00:06:30] the exception to that again is those losses are deductible due to a federally declared disaster. What's interesting is that holds true for both casualty losses and theft losses. So typically when we're talking about a federally declared disaster we're focusing on casualty losses, Destruction due to major storms or earthquakes, Earth slides, those kinds of catastrophic disasters.
Jeremy Wells: But [00:07:00] it's entirely true and possible that some theft losses might occur as a result of that as well. So, uh, for example, uh, in Louisiana during Hurricane Katrina, back during the mid 2000, there was a lot of looting that resulted after, uh, that storm passed through, uh, power was out for days, and there was just a general lack of, uh, any sort of law enforcement, [00:07:30] uh, in much of that city. And so that resulted in a lot of theft, a lot of looting. There were losses there, uh, that were a result of that federally declared disaster area that were not strictly casualty losses. Now, this is pre Tax Cuts and Jobs Act. But we could easily see situations like this happening under the Tax Cuts and Jobs Act period 2018 2025 as well. So that all comes out [00:08:00] of uh Internal Revenue Code section 165. See the key thing here is the difference between those three types of activities that would give rise to the loss, those connected to a trade or business, those connected to a transaction entered into for profit, and then those that are strictly personal. That distinction, especially between entered into for profit and strictly personal, [00:08:30] is going to be key to understanding a lot of these theft losses. Uh, and whether they are in fact deductible, uh, or not. In general, when we look through the law, when we look through guidance, when we look through court cases centering around theft losses, there are essentially three criteria that have to be met by the taxpayer in order to credibly claim a theft loss.
Jeremy Wells: The first one is that that theft occurred under the [00:09:00] law of the jurisdiction wherein the alleged loss occurred. In other words, that event has to be considered theft. Generally speaking, under the laws of typically the state in which that loss is claimed. I'll explain a little bit more about what this means. And this is essentially a judicial doctrine that has arisen under this concept of theft law. This isn't really in [00:09:30] either the Internal Revenue Code or even in the Treasury regulations or any other administrative guidance. This really comes out of judicial interpretations. So you won't find this in the code. You won't even find this in the regulations where you'll find this as in court cases interpretation of when a theft has actually occurred because that's really, uh, not well defined in the law or even in the administrative guidance at all. 165 C3 says [00:10:00] whenever we have a theft, uh, that is a potentially deductible loss. So what do we mean by theft? And the courts have come back to say, generally we're talking about theft as defined within the state laws, where that taxpayer is claiming that loss. The second criterion here is we have to know the amount of the loss.
Jeremy Wells: This is similar [00:10:30] to what we discussed in last episode with Casualty Losses. We have to have some way of establishing the value of what was actually lost. And so there are some relatively easy ways to do that we can look at the insured value, we can look at an appraised value, or we can make a reasonable estimate of what that value might be for some things that you would typically imagine, uh, being, [00:11:00] uh, lost due to theft, uh, especially in terms of tangible assets, that might be a little difficult. We might be talking about jewelry or collectibles that have a, uh, fair market value that's not directly, uh, obvious. Maybe we would arrive at that valuation by an appraisal, uh, or maybe an insured value. But if we don't really have an appraisal prior to the theft and [00:11:30] we don't really have an insured value, then it might be difficult to to get a, a truly, uh, reasonable estimate of what that value is. However, in general, when we're talking about thefts that involve securities or cash, it's going to be straightforward what the actual valuation of those losses are. And then finally, we need to know the date the tax payer discovered the loss. And that's very important. That's going to come up quite a bit throughout this discussion of theft [00:12:00] losses, because there are two separate dates that can occur here. Now they might be the same date, but a lot of times they're not.
Jeremy Wells: The first date is the date that the theft actually occurred. When was that asset taken? Uh, illegally. That could be one date. And then a different date. Could be when the taxpayer actually realizes [00:12:30] that theft has occurred. That could be the same day, maybe a few hours later. It could be a few days later. It could be weeks, months, even years later. And that definition of discovered as far as the loss goes, can become even more nuanced when we consider the possibility of reimbursement or insurance covering that loss. So we'll talk a little bit more later on about what we actually mean [00:13:00] by the date that the taxpayer discovered the loss. When we're talking about when the taxpayer can actually claim that loss, the tax year in which taxpayer can actually claim that loss, because it's probably not going to be the same year that the theft occurs. If there is some time in between the theft occurring and when the taxpayer actually discovers the theft. And then really, if there's any chance of either recovering [00:13:30] what's been stolen or getting reimbursed for what's been stolen through insurance or some other way, that's going to affect the actual timing of when that loss can be taken. So there's a lot that goes into determining that date of when the taxpayer discovered the loss, and when the taxpayer can actually claim that loss. Like I said, the definition of theft for federal tax purposes [00:14:00] really depends on state law, but broadly read.
Jeremy Wells: So if we actually look through case law, mostly coming out of the tax court and some federal courts for federal tax purposes, there is, quote, a word of general and broad connotation intended to cover any criminal appropriation of another's property to the use of the taker, particularly including theft [00:14:30] by swindling, false pretenses and any other form of guile. This is all coming from a seminal court case involving theft losses. Edwards The Bromberg uh. And this was in 1956. It has been long and well established that whether a loss from theft occurs within the purview of the Internal Revenue Code depends upon the law of the jurisdiction where it was sustained, and that the exact nature of the crime, whether larceny [00:15:00] or embezzlement, of obtaining money under false pretenses, swindling, or other wrongful deprivations of the property of another is of little importance, so long as it amounts to theft. This definition of theft for federal tax purposes is is really interesting. If you read through this paragraph and I cut out a lot of citations to other case law and things like that going on in this, because what you see in this [00:15:30] case is the court really trying to struggle, um, with this definition of theft for federal tax purposes, because the law itself IRC 1621665 is so vague it just uses the word theft and never really defines what that means.
Jeremy Wells: But then we have, on the other hand, state law, uh, defining what theft might be, but every state and this is what the courts found out, every state can have a different interpretation [00:16:00] of what theft means. And some states outlaw theft and then define a bunch of different kinds of theft, like we get out of that quotation. There are there's larceny, there's embezzlement, there's swindling, there's appropriation under false pretenses. Some states list all of those out as separate crimes. Uh, I believe New York was the example. New York State was the example where larceny, embezzlement, theft, those are all separate [00:16:30] crimes and that state's laws. But then other states will lump all of those different kinds of crime together under the heading of theft. So if we're relying entirely on state law to determine what theft is, we're going to get probably about 50 different definitions, one for each state. But we don't really have a federal definition of theft. That's not a federal crime, although it is the [00:17:00] term used in the Internal Revenue Code. So what the court ends up doing is say we're going to look at state law where the theft actually occurs, and see if this qualifies as theft in that state. However, and this is the way the courts kind of leave the door open for a little bit broader interpretation is this last bit here, the quote, however, [00:17:30] the that exact nature of that crime is of little importance, so long as it amounts to theft.
Jeremy Wells: In other words, you know it when you see it. So we're going to look at state law. If state law defines this as a theft, we'll take that. But we're not going to worry too much about whether this particular crime or this particular event qualifies as [00:18:00] theft. Uh, strictly speaking. And we're not going to try to invent a definition of theft. We're just going to know it when we see it. And I think that's a really interesting approach to it. So if you're dealing with a taxpayer that has suffered through a situation that you think might qualify as a theft loss, then it's really important to take into consideration that taxpayers attempt under state law, to address the situation. [00:18:30] That might look something like filing a police report, talking to an attorney, filing an insurance claim, and seeing what that process ends up turning up for the taxpayer. Now, that may or may not be conclusive for that taxpayer and for you when it comes to claiming this event actually produces a theft loss under federal law in terms of claiming [00:19:00] this on a tax return. Now, IRS has taken this judicial definition of theft as looking at state law, not relying entirely on it, but using that as a starting point, and has incorporated that into Treasury regulations 1.1658. And then also revenue ruling 2009 nine that those are a couple of different examples [00:19:30] of some administrative guidance coming out of Treasury and IRS, where they essentially adopt this judicial definition of theft when it comes to federal tax law.
Jeremy Wells: So that's pretty much been the standard for about, uh, well over half a century now in terms of federal tax law. It's theft. If state law, broadly speaking, says it's theft. Now back to the issue of timing. [00:20:00] When is when does the theft actually occur versus when does the taxpayer recognize and become aware that theft has occurred? A theft loss is treated as sustained during the tax year, in which the taxpayer actually discovers the loss. And this references back to, uh, IRC section 165. It's also in Treasury Regulation [00:20:30] 1.1 One D3. So both the statutory law and the administrative law here point to the actual date of discovery of the theft. So again, that could be a completely different date from when the theft actually occurred. That could be weeks, months, years later. That's the date we're actually worried about. When did the taxpayer discover that the theft had occurred? [00:21:00] Not necessarily. When did the theft occur? But there's a caveat here. And this comes out of the Treasury regulation. If in the year of discovery, the taxpayer has a, quote, reasonable prospect of recovery on a claim for reimbursement, meaning the taxpayer has filed an insurance claim and insurance has not yet denied that claim, there's [00:21:30] still a strong possibility that insurance will cover that loss, or if that taxpayer has, for example, press charges against the, uh, the the thief, or there's a pending court case and the result of that has not been determined yet, but there is a positive chance that the taxpayer can recover some, some or all of that loss by way [00:22:00] of the court system or insurance.
Jeremy Wells: Then there is no deductible loss. Yet the loss will not be sustained until, quote, the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received. That's coming out of that. Treasury regulation 1.16513. So we've got a caveat [00:22:30] here. In general, the date of the loss for, uh, in terms of being able to claim that on a tax return, the date of the loss is when the taxpayer discovers the theft, unless that taxpayer has a reasonable prospect of recovery. And then we have to wait until the taxpayer can ascertain with reasonable certainty whether or not that [00:23:00] reimbursement will be received. This is important to keep in mind if you have a if you are a taxpayer or you're working with a taxpayer who is in the middle of litigation or an insurance claim resulting from a theft situation, then you can't file that. You can't report that on a tax return, on a federal tax return as a deductible event until there's a reasonable certainty [00:23:30] whether or not reimbursement is going to be received.
Jeremy Wells: It's not that you go ahead and claim it, and then wait until that reimbursement is received and see what happens with that. It's not that you claim it when it's been discovered, and then see how the courts handle it, or see how insurance handles it. You have to wait until that, uh, the outcome of that process is actually, uh, either known or within a reasonable certainty by that taxpayer. [00:24:00] It's entirely possible that process takes weeks, months, years after the taxpayer has even discovered the theft. So it can be tricky, uh, dealing in this situation. I've mentioned digital assets and cryptocurrency earlier. This is one of the issues that can involve claiming theft losses, uh, with some of those situations, because you might have, uh, three very different dates, with relatively long periods of time [00:24:30] between the dates, the date that the theft actually occurs. If there was some scam or scheme where by A a scammer was able to steal a certain amount of cryptocurrency, for example from the taxpayer, and then maybe at some later date, the taxpayer actually discovers that theft. And then we need to wait even longer to see if there is some reasonable chance of [00:25:00] recovery, if there is some recourse that that taxpayer has against the scammer, if there is any way to, uh, get back whatever that cryptocurrency or even some physical asset was actually stolen, this can lead to a lot of confusion, a lot of frustration, especially as the time periods between these dates, uh, continues to increase, however.
Jeremy Wells: That's, uh, that's what tax law [00:25:30] tells us, that we need to be able to wait for those dates. Something to keep in mind here is that just a simple disappearance is not a theft. The simple disappearance of money or property is not a theft. There is a, uh, there's a tax court case, a seminal one from 1951, Allen v Commissioner, where the taxpayer lost a piece of jewelry in a public place, a, uh, [00:26:00] museum. The taxpayer staff searched throughout the museum, the, uh, store that the taxpayer bought the piece of jewelry from, published in the local newspapers, uh, an announcement about the piece of jewelry saying that it had been lost and if anyone could return it, and then the taxpayers file, of course, filed a police report. The taxpayer never recovered the jewelry [00:26:30] claimed a theft loss. However, the taxpayer couldn't prove to the court that someone actually stole the piece of jewelry. But that was the missing link in this case. After IRS denied the claim and the Tax Court found that there was no actual proof that a theft had occurred, the jewelry was just lost. And so the court ended up agreeing with the IRS and denied the theft loss deduction there. So it's not enough just to say that this, uh, you know, valuable [00:27:00] asset, whether that's cash or some form of property such as jewelry was lost and it was in public.
Jeremy Wells: Therefore, someone must have picked it up and picked it up and taken it. That is not proof enough for the IRS and for the courts in order to be able to deduct that theft loss. Now, when we take all of this into account, I want to juxtapose this a little bit to how we think about casualty losses, because although casualty [00:27:30] losses and theft losses come out of the same section of the Internal Revenue Code, and the reporting is similar and the logic is similar, there are some important differences here. So again, the definition of when a theft occurs is pretty loose. And it's based on judicial interpretation of what we mean by theft. The courts could override that precedent at any time. And for federal tax purposes, we would get a different definition of [00:28:00] what theft means for casualty losses, especially under Tax Cuts and Jobs Act. We have a pretty strict definition of what a casualty is. It's a federally declared disaster area. And so if you go back and listen to the prior episode, if you haven't already, when we're talking about casualty losses, we're looking for that FEMA, that Federal Emergency Management Agency, we're looking for that FEMA declaration of a national disaster. On the other hand, for theft loss, we might have a much looser [00:28:30] definition of what a theft is, and therefore we're going to have a more difficult time deciding and determining whether a theft has actually occurred.
Jeremy Wells: Also, the date of when that theft loss is actually deductible is going to depend on the taxpayer discovering that the theft has occurred, and when the taxpayer has exhausted all attempts at recovering or getting reimbursement [00:29:00] for that theft, as opposed to the casualty loss, where we have some rules about when that's actually deductible. Pretty much when we have that declaration of the natural disaster. And then we also have some rules about being able to elect to take that loss in a prior year. That election does not exist for theft losses the way it does for casualty losses. So it's important even though we're talking about similar rules, we're looking at the same code section. [00:29:30] There are important distinctions between casualty losses and theft losses in terms of the definition of when that loss occurs and the the actual date and therefore tax year that we can claim that loss. One particular kind of loss that is outright not necessarily a theft loss, although there are some limited cases where it could be, is when we have a decline in stock value, the [00:30:00] taxpayer can't take a theft loss for a decline in the value of stock owned by the taxpayer when it declines due to a fluctuation in the market price of the stock or other similar causes. You can imagine a situation in which a taxpayer has Purchase some stock in a company.
Jeremy Wells: The stock price of that company tanks. You decline sharply in value. And that taxpayer feels [00:30:30] cheated. Feels swindled. Uh. This is a lot of the, uh, the penny stocks, the pink slip stocks, the, uh, the sort of fly by night investments. However, uh, those are strictly, uh, written off as, uh, not theft losses. A taxpayer cannot claim a theft loss for a decline in stock value due even to the disclosure of accounting fraud or other illegal misconduct by [00:31:00] the officers or directors of a corporation, because the officers or directors did not directly have the specific intent to deprive that particular shareholder of money or property. That's a judicial interpretation that comes from a tax court case from 1975. Payne v Commissioner, and that was affirmed on appeal. So what we get from that is if you have been, uh, investing into a company, [00:31:30] even if that company has fraud, illegal misconduct among the board of directors, the officers, even in that case, even when the loss of the value of that stock is due to illegal conduct, that's still not a theft loss, uh, for at least for federal tax purposes, in order for that theft to occur, there has to be a specific individual identified [00:32:00] as taking, uh, and intending to take that taxpayer's particular assets. You can think of some, uh, somewhat recent examples, uh, think about, uh, companies that have, uh, I relied on inflated and even fraudulent financial statements or positions in order to appear as a better investment. [00:32:30]
Jeremy Wells: Uh, Enron, for example, where a lot of uh, individuals invested into that company realized after the fact that all of that was inflated, that the company really wasn't much worth as much as the stock price indicated. So the stock value tanks. And then those investors are left having lost a lot of their, uh, investment, sometimes even life savings in those cases, even though that's the result of a lot of [00:33:00] fraudulent and illegal activity and behavior and reporting, that's not going to qualify as a theft loss for federal tax purposes. One particular kind of scheme that Is carved out of the theft loss discussion is Ponzi schemes or Ponzi type schemes. Losses resulting from a Ponzi type scheme [00:33:30] are theft losses entered into for profit, and thus they are deductible under IRC section 162 C2, not C3. Now, C2 is those transactions that are entered into for profit with a profit motive. C3 is the ones that are neither trade nor business or entered into for profit. And so those are the personal losses that are nondeductible under Tax Cuts and Jobs Act. [00:34:00] 162 C2 are the transactions that are entered into for profit with a profit motive. By definition. Irs in Revenue Ruling 2009 nine Defined Ponzi schemes and Ponzi type schemes as that first group entered into for profit and therefore still deductible even under the Tax Cuts and Jobs Act.
Jeremy Wells: And because they are defined [00:34:30] as deductible under IRC 162 C2, that is also excluded from the limitations of section 165 H that I talked about back in the casualty loss. Uh, episode 165 H says that those personal casualty and theft losses are subject to the $100 reduction. And then that 10% of AGI floor. And then on top of that are [00:35:00] treated as miscellaneous itemized deductions, which is limited to 2% of AGI. And so that, uh, set of limitations does not apply to losses deducted under 162 C2. Those transactions entered into for profit, and so we can ignore all of that when it comes to these Ponzi type schemes under that revenue ruling. 2009 nine. In [00:35:30] fact, in that same year, IRS released Revenue Procedure 2009 20, which establishes a safe harbor for Ponzi type schemes. And what this optional safe harbor does is it provides taxpayers with a uniform way for determining their theft losses, avoiding potential, uh, difficult problems of proving and in determining [00:36:00] how much income in prior years was a fictitious or a return of capital. And it alleviates compliance, administrative burdens on both taxpayers and the IRS. That's the language coming out of that revenue procedure. In other words, like any safe harbor. The idea here is to provide a taxpayer friendly way of reporting what is a straightforward application of the law with with respect to a particular case, if [00:36:30] the taxpayer meets certain criteria.
Jeremy Wells: So under these criteria, the taxpayer can claim that this is in fact a loss due to a Ponzi scheme and therefore qualifies as a transaction entered into for profit, and is a deductible theft loss. Now these terms are all defined in the revenue procedure. So it's important if you've got a case that you think is going to qualify, that you go through that revenue procedure [00:37:00] and see if a particular taxpayer does actually qualify under it. But first, the taxpayer has to be a qualified investor. That taxpayer suffered a qualified loss. That qualified loss resulted from a qualified investment, and then the qualified investment was in a specified fraudulent arrangement. In general, this all comes back to you have a taxpayer entering [00:37:30] into a transaction or a series of transactions that are entered into for profit that are in a Ponzi or Ponzi type scheme. If the taxpayer qualifies and meets those four criteria, the taxpayer is qualified investor. It's a qualified loss from a qualified investment in a specified fraudulent arrangement. Then, the taxpayer can claim that Ponzi scheme loss without proving a criminal conviction. And [00:38:00] then there is a decision. If the taxpayer is not going to pursue any sort of third party recovery, then that is a 95% limitation on the claim there. So if you have a taxpayer that invests $100,000 into a Ponzi scheme, loses all of that investment and then decides not to pursue any sort of recovery, [00:38:30] then that taxpayer can now claim a theft loss of up to $95,000, or 95% of the amount invested.
Jeremy Wells: If the taxpayer is pursuing recovery, then that loss is limited to 75% of the amount invested. So in that case, that taxpayer could claim $75,000 as a loss, and that would all be claimed under that, uh, safe harbor under revenue procedure 2009 [00:39:00] 20. And there are rules in that revenue procedure for how to report this on the tax return, it's still going to be reported on a form 4684, which I'll talk about in a minute. But there's going to be some language added to that. And that specific language is spelled out there in the revenue procedure. Now, interestingly, what happened after not long after this revenue procedure, 2009 20, [00:39:30] was promulgated by IRS. There were a few prolific cases of Ponzi type schemes happening where the ringleaders of the schemes actually died before they could be indicted and prosecuted for these crimes. That made it difficult for those taxpayers to be able to claim the loss, because part of the definition of it being a qualified [00:40:00] investment under that safe harbor was that the ringleader of the scheme, was actually indicted and prosecuted for the crime. Well, if the individual dies, then the prosecution is not going to be able to continue that case. So what happens if that individual dies before a formal indictment is handed down? By definition, under that safe harbor, there's no way, then, for [00:40:30] that taxpayer to claim the loss, even though that's not the taxpayer's fault.
Jeremy Wells: So a couple years later, IRS issues Revenue Procedure 20 1158, which expands the definition of qualified loss in the case of a scheme leader's death. And so essentially, IRS went back and redefined its own term of qualified loss and changed the qualified investor's discovery year, as that phrase is used in the revenue procedure [00:41:00] as the investor's tax year in which either an indictment or complaint is filed against that scheme leader or the complaint or similar document is filed, or the death of the lead figure occurs, whichever is later. So in these cases, if that scheme leader never makes it to trial due to death, then the taxpayer can use that year of that leader's death. That allows [00:41:30] victims of these Ponzi schemes to claim a loss, even when the lead figure dies before indictment. So that is a bit of a safe harbor for the safe harbor when it comes to those Ponzi type schemes. Now, let's look at some additional qualifications here for what makes, uh, a scam deductible. Very recently, uh, in fact, in 2025, the year of [00:42:00] recording here, in March of 2025, The IRS chief counsel provided a memorandum clarifying five different scenarios where a taxpayer may have deductible theft losses but does not qualify under that Ponzi style scheme.
Jeremy Wells: Safe harbor. So, by definition, what the IRS chief counsel's office did was come up with five scenarios that are relatively common scams but don't [00:42:30] qualify for that safe harbor treatment. So these are edge cases because we have situations where they're not going to qualify under the Ponzi scheme, safe harbor, but they also appear to be deductible as activities engaged in for profit and not just personal losses, which are not deductible under the Tax Cuts and Jobs Act. So in each of these cases, [00:43:00] the chief counsel lays out the same criteria. It's involving a taxpayer who invested funds, uh, from IRA and other brokerage accounts, uh, into, uh, some sort of investment with a prima facia profit motive. And that's the term used in the, uh, chief counsel advice. So in other words, we're explicitly stating that the taxpayer has that profit motive, and [00:43:30] therefore this should seemingly qualify as a case where the, uh, the loss is deductible under 165 C2 as a transaction entered into for profit. The added qualification here is that the taxpayer did not know the scammer. So there is no known party issue here, could not recover the funds or claim insurance. So there's no expected reimbursement. There's absolutely [00:44:00] no chance of any sort of recoverability here. And that also law enforcement confirmed that there is little to no prospect of recovery. So we're probably never going to find the culprit in these cases.
Jeremy Wells: The five types of scams are a compromised account scam a pig butchering investment scam. Talk about that one here in a minute. A phishing scam, phishing scam, romance scam and a kidnaping scam. Now again, those common [00:44:30] setups, uh, are are the same for each of these five cases. In the compromised account scam, the scammer convinces the taxpayer that her investment accounts were compromised and to authorize distributions to a new account controlled by the scammer. The taxpayer invested with a profit motive, and she will recognize income from the IRA distributions and capital gain or loss from the sale of assets. But that gives [00:45:00] the taxpayer basis in the stolen funds to calculate the deductible theft loss. And now there are more details for these cases in the chief counsel advice. But the idea here is that the scammer somehow contacts, either by email or phone the taxpayer and convinces the taxpayer, through gaining her trust, to make these financial moves. Usually that involves liquidating some sort of investment account like an IRA or a brokerage [00:45:30] account, and then transfer those funds that distribution into some account that is then controlled by the scammer. Unknown to the actual taxpayer, in that case, the taxpayer is going to have to claim the income from the distribution and capital gain from the sale of that the whatever was held in that brokerage account. But that's going to give that taxpayer basis to then claim [00:46:00] the loss.
Jeremy Wells: The theft loss. Now a pig butchering scam is a little bit different. And this is actually important for those dealing with cryptocurrency and digital assets. These have become fairly popular over the last couple of years, especially in the crypto world. So in a pig butchering scam, the scammer provides some too good to be true. A large return promises of large returns [00:46:30] in order to get the taxpayer to invest. But this usually starts out with a relatively small amount. Because it sounds so good to be true, the scammer convinces the taxpayer to invest a relatively small amount, maybe just a few hundred or a couple thousand dollars, and then the scammer actually provides those returns. This induces the taxpayer Air to invest even more. And this is where the [00:47:00] pig butchering part of this comes in. Because essentially what happens is a series of transactions where the taxpayer fattens up. And that's the that's the term the scammers used the old saying that pigs get fed, hogs get slaughtered. Right. And this is what happens here. So the taxpayer starts investing small amounts, sees big returns, starts investing relatively larger amounts, keeps getting those returns and keeps increasing the amount of the investment [00:47:30] until it hits some critical amount where the scammer then withdrawals all of the investment transfers that into an account controlled by the scammer. And when the taxpayer attempts to withdraw their investments, uh, usually this is done through a website and the website will give some sort of error message.
Jeremy Wells: The taxpayer then tries to contact customer service through the website and customer service never responds. And it's at this point that the [00:48:00] taxpayer realizes something is up and that a theft has occurred. Again, in this case, the taxpayer invested with a profit motive. She's going to recognize income from the distributions that she took from an IRA in order to be able to invest or capital gain or loss from the sale of any assets in a in a brokerage account. And then that's going to give that taxpayer basis, and that basis is going to allow the taxpayer to claim the theft loss in [00:48:30] those investments. This is, uh, these pig butchering scams. Like I said, they become relatively common in the crypto, uh, world. And so it's relatively easy to imagine doing this, maybe not necessarily with actual cash, but doing this with cryptocurrency. So invest a little bit of cash into some sort of cryptocurrency or a little bit of cryptocurrency into a different kind of cryptocurrency or digital asset. And then again, repeat that process of [00:49:00] investing more and more as those gains are actually realized. And then finally, once you reach a critical point, the scammer, uh, disappears with the funds. A phishing scam phishing scam. This is a type of email scam where the taxpayer sends the uh, or receives a message from the scammer stating that her accounts were compromised.
Jeremy Wells: Uh, and a link to click to reset those accounts or to address the situation. [00:49:30] Now clicking that link looks like it takes the taxpayer to a legitimate site, but what it actually does is it gives the scammer control of the taxpayer's computer. And the scammer then logs all of the activity, all of the keyboard inputs, all of the mouse clicks for that taxpayer. And once the taxpayer logs into her account in order to try to restore them or deal with [00:50:00] the claim that they've been compromised, then at that point, the scammer has all the information she needs to be able to log into those accounts and then withdraw funds into the Scammer's account. Again, this is a very similar situation to the first two cases. There is a profit motive here with those investments, and the taxpayer is going to recognize either income from IRA distributions or capital gain from brokerage accounts, uh, get the basis and then be able to claim [00:50:30] that theft loss. The romance scam is interesting. This is one where a scammer would create, over time, a, uh, virtual romantic relationship with the taxpayer. And then once the scammer has reached a certain level of trust with that taxpayer is going to claim to need funds to provide for a loved one's dire medical needs. Some sort of medical procedure is necessary, [00:51:00] and it's going to take a lot of money to pay for that.
Jeremy Wells: After transferring the funds, the scammer breaks off contact and has never heard from again. Uh, in this case, though, and this is different from the other three, there is no profit motive here. This is this is just simply a transfer of personal funds to another individual. There's no expectation of some sort of return on investment here. So in this case that is a personal [00:51:30] loss. That's actually nondeductible under the Tax Cuts and Jobs Act. Now notice this is a very subtle difference right. In the prior cases we had a situation where the taxpayer was moving funds around in the expectation of either, uh, making profits or maintaining some sort of investment. And so that qualified as a for profit transaction. In this case, there's no expectation of profit here. So that makes the loss here the theft loss nondeductible. However, if [00:52:00] the taxpayer distributed funds out of an IRA or withdrew funds from a brokerage account, there is going to be either ordinary income or capital gain income or potentially capital loss, depending on the value of those assets arising from these, uh, these transactions, these liquidations. And then finally, in the kidnaping scam, the scammer contacts the taxpayer claiming to have kidnaped a close relative or purporting to be law enforcement, claiming [00:52:30] that a relative has been arrested and that that relative needs money, uh, for bond or bail or to secure release. Then the taxpayer transfers the funds and the scammer takes off with the funds.
Jeremy Wells: Now, this also, uh, like the romance scam is. There is no profit motive here. And so again there's no deductible theft loss. So the idea here behind this chief counsel [00:53:00] memorandum, this chief counsel advice is to give us some scenarios that give us some way of looking at a real taxpayer's case and comparing that to what we're we're seeing in that real case and determining whether this is, in fact, a deductible loss. Uh, again, the, uh, the loss for a theft is generally going to be claimed in the year of, uh, the discovery of that [00:53:30] theft. And that's going to be the year that the taxpayer can claim that loss. If there is any sort of claim for reimbursement or for insurance, then that is going to delay the deductibility of that claim. Reporting theft losses on form 4684 is very similar to the process of reporting those casualty losses. So go back and listen to the casualty Loss episode, where I discuss how to report those [00:54:00] losses on form 4684, the form for personal and business or income producing losses in section A and section B. It's an identical process of reporting those losses, whether it's a casualty loss or a theft loss, you're still going to begin with the cost or adjusted basis. You're going to determine if insurance or reimbursement produces a gain from that. You're going to calculate the change in the fair market value due to theft. [00:54:30]
Jeremy Wells: Generally, that's going to result in a fair market value of zero for the taxpayer. If the entire asset was stolen and not recovered, and then you're going to take the smaller of the basis or the change in fair market value, and then you're going to reduce that amount by any insurance or reimbursement allowed, and then you're going to repeat that for each property if there was multiple properties involved in that theft event. There is a special section C on form 4684 to report the Ponzi type [00:55:00] investment scheme losses that I discussed earlier under that revenue procedure, 2009 20. And so you're going to have to look at that section if you're, uh, if the taxpayer is involved in that kind of situation, you're essentially going to look at the initial investment, any subsequent investments and any income that was reported as a result of that investment activity on any prior year tax returns, and altogether that, uh, minus any withdrawals [00:55:30] is going to give you the total qualified investment, then you're going to either take the 95% if there's no third party recovery, or 75% if the taxpayer has a potential third party recovery. And then you're going to reduce that by any insurance or any other kind of recovery to determine the deductible. Theft. Loss. There's also a section there where the taxpayer is going to essentially verify and affirm that she actually qualifies under that safe harbor under revenue [00:56:00] procedure, 2009 20.
Jeremy Wells: And like I said at the top of the episode, I want to briefly discuss an interesting case. This is Booth v Commissioner from 1984. In 1959, Ferris Booth purchased a soldier's additional homestead right from, uh. This was a particular set of rights that were granted to, uh, Civil War veterans to apply for [00:56:30] and then receive an interest in federal lands. Now, Ferris Booth didn't fight in the Civil War, but these rights were sellable by the holders. And so eventually Booth was able to purchase these rights from an estate sale from someone who had purchased the rights from the original veteran who earned this. The next year, in 1960, Booth sold those rights to R.L. Spoo Spoo. Unfortunately, when Spoo attempted to exercise those rights, [00:57:00] that's when they did a title check and realized that the rights were not valid, that the rights that had been sold at some point before Booth acquired them were actually not the real, uh, rights to, uh, that, uh, that that veteran had actually earned in the first place. So Spoo sued Booth and then won in 1977. Now, Booth claimed a theft loss on his 1977 tax return. [00:57:30] The IRS denied the claim, and then Booth petitioned the Tax Court because Booth thought this should have been a theft loss. The Tax Court did an en banc Uh, decision. And this is where all of the judges at the time, it was 18 judges.
Jeremy Wells: They all weigh in on the case and the decision here. The Tax Court decided that it was a long term capital loss, not a theft loss. But of the 18 judges, only ten [00:58:00] of them were in the majority, a slim majority, ten out of 18, while the other eight supported two dissenting opinions. And one of those was written by Judge Corner. K o r n e r wrote one of the dissents, arguing that the judgment against uh Booth resulted from not one transaction, but two separate transactions. We had the original purchase of the rights by Booth, and then later we had the sale to Spoo. So those were two different transactions. And corner argued [00:58:30] those are those two transactions should be treated differently in terms of losses. Originally the, uh, the purchase of that of those rights that was in fact theft because the rights were invalid, they didn't actually exist. So whatever, uh, whatever Booth paid in order to purchase those rights, that was an invalid transaction. This occurred in State of Arkansas and Arkansas. State law [00:59:00] treated this as a form of theft. And so that part of the transaction was, in fact, a theft loss. The other part of the transaction where Booth tried to sell those rights to Spoo Spoo, won the court case and got reimbursed by Booth. That part of the loss. Once you subtract the theft part, that part of the loss was long term capital loss for Booth.
Jeremy Wells: That's what corner argued in the dissent. But remember, the tax court [00:59:30] case went the other way. The Tax Court case said it was all capital loss. But then the Ninth Circuit Court of Appeals actually agreed with corners, descent and a very short opinion just two paragraphs, the second of which the Court of Appeals essentially said corner was right on this and reversed the Tax Court decision, remanded the case back to the Tax Court and said, rewrite your opinion based on corner's dissent. I really like this case because it shows that even some [01:00:00] of the smartest minds in federal tax law, we're talking about the 18 judges of the US Tax Court. These are some of the smartest people in the country at the time in terms of federal tax law. Out of 18 of them, ten went one way, eight went a different way. And even then they couldn't agree on how to treat this case. And if you agree with the Ninth Circuit Court of Appeals, even they even the majority of the Tax Court got [01:00:30] it wrong. So I think it's really interesting to think about this, that there are cases where the law is not clear. The treatment of a transaction is not clear, and that even very smart people in terms of federal tax law can disagree and ultimately be wrong about how to treat these transactions.
Jeremy Wells: Now, I asked tax, Twitter, uh, the day before I'm recording this, I asked tax Twitter in a poll on, uh, the website formerly known as Twitter now X. Uh, I asked them, [01:01:00] I simplified this down. I said taxpayer A purchases a piece of land and later sells taxpayer B when B goes to sell the land. The title check shows the original seller didn't have the title, so a never truly owned it. B sues A and wins. What's the character of A's loss? Now, interestingly enough, 32% of the 72 respondents said that it's neither theft nor capital loss. I'm not sure where they got that, but 28% said [01:01:30] that it's only a theft loss, 28% said it's only a capital loss, and just 13% said It's part theft, part capital. So only 13% of the respondents here agreed with Judge Corner and with the Ninth Circuit in that it was part theft loss, part capital loss. So again, I just want to say there are a lot of smart tax people out there and they can disagree and they can even be wrong. The important part is that we keep [01:02:00] thinking about these issues. We keep reading the law, we keep thinking about it. And that's exactly why I do what I do with this podcast, trying to help us all think about the law. If you got some value out of this episode, please jump on to Apple Podcasts, leave a review, let me know what you found helpful, and help support this show and get it into the podcast feeds of other tax professionals. Thanks very much.