Taxpayer Salvages Theft Loss Deduction from Investment Scam

Internet investment scams continue to abound. If a client is victimized by such a scam, at least there’s a silver tax lining: The client may be able to claim a theft loss on his or her tax return. A new case decided by the Tax Court illustrates this point (Leslie, TC Memo 2016-171, 9/14/16).

For tax return purposes, theft losses are lumped with casualty losses. You can only deduct the excess of the total above 10 percent of your adjusted gross income (AGI) after subtracting $100 for each casualty or theft loss event. For example, if your AGI for the year is $100,000 and you suffer two separate losses totaling $20,000, your deduction is limited to $9,800 [$20,000 – (10% of $100,000 – $200)].

In the new case, things became even worse for a taxpayer, a California resident, embroiled in complicated divorce proceedings. Through a recommendation by a friend she trusted completely, she was victimized by an Internet scam in 2008.

The scheme involved a large shipment of diamonds in Africa that needed some money to allow their export. Purportedly, the “investment” would return $1 million once the diamonds were in hand and then resold. The taxpayer didn’t sign any agreement and had no proof of the arrangement other than a document sent to her by the scammer, a “Foreign Credit Commission” (FCC), which turned out to be a fabrication.

There was never any return on the taxpayer’s investment. Instead, there were only delays, followed by more excuses, followed by more delays. Midway through 2009 the taxpayer realized she had been duped. Her friend reached out to the FBI and the taxpayer contacted the police, but she never filed suit or made any other claim against the scammer because she simply couldn’t find him.

On her 2009 tax return, the taxpayer claimed a $405,000 theft loss. The IRS challenged the deduction and the parties left it up to the Tax Court to decide.

After examining the facts, the Court concluded that the African diamond scammer’s representations were fraudulent and the whole deal was a scam. It based its determination on the following reasoning:

What little documentation existed was phony.

The purported return on her investment (double her investment in only 10-30 days) was “too good to be true.” This is an obvious indicator of a fraudulent scheme.

The lack of a contract was far more consistent with a scam than with an investment. (The taxpayer never received a written contract before wiring her money.)

The Tax Court also said another element of the offense—that a promise to the taxpayer must be made with the intent not to perform—was satisfied because it could not think of a plausible intent on the scammer’s part other than to defraud the taxpayer of money. In addition, the Court found that the taxpayer actually relied on the scammer’s promise of a high return. California courts have held that even reliance by a foolish victim of an absurd fraud is nonetheless reliance.

Finally, the Court noted that neither a criminal case nor a civil suit was required to prove a theft loss. In the past, the Tax Court has held that a taxpayer doesn’t even need to know who the thief is.

Make sure your clients are aware of the tax rules in this area. A theft loss deduction might take some of the sting out of the situation.