Theft, Scam, and Casualty Losses

In episode 51 of How Tax Works, Matt Foreman discusses theft losses under section1 165 of the IRC, including pig butchering, rug pulls, and Ponzi schemes, discussing whether the losses are deductible and in what amounts

How Tax Works, hosted by Falcon Rappaport & Berkman LLP Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions.

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Transcript

Matthew Foreman [00:00:00]:
Welcome to the 51st episode of How Tax Works. I'm Matt Foreman. In this episode, I'm going to be talking about theft losses and how they're deductible. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions we all make before we get started.

Matthew Foreman [00:00:41]:
Administrative stuff, as always. Episodes every two weeks. Next episode is why you probably shouldn't try to go after QSBs. I'm really doing it because I keep getting the same questions and it's time to answer it and just be able to, hey, you should listen to this. I get the same questions and it's the same issues. And I think that. And I'm not naming names, but certain groups, people are overhyping it. So I'm gonna, I'm gonna talk about it because I think it's important.

Matthew Foreman [00:01:09]:
I think it's important to do. I think it's an interesting topic anyway. All right, so if you have any questions, comments or constructive criticism, you can email me my FRP email address. You can find on on via your favorite search engine and probably AI at this point. Upcoming webinars and speaking agents are on the How Tax Works landing page and the FRB website. So let's, let's talk about it. A lot of, a lot of this is in CCM 2025 11015. A lot of it.

Matthew Foreman [00:01:39]:
At least the concepts of it. I'm going to go into a lot more detail. I actually did this as a webinar, which maybe you attended, maybe you didn't, which I talked for two hours. I'm going to do this in like 20, 25 minutes. I'll do this pretty quickly. I'm gonna. I don't talk about the CCM in this because I didn't think it was really necessary because I talk about a lot of the stuff that goes in. So.

Matthew Foreman [00:02:00]:
But I think it's important. So you need an introduction to this. Right? So historic ones are really interesting. Snake oil, which still exists today. There are some nutritional supplements that have no evidence they do anything. So it still exists. But those are worthless pseudo medical remedies promoted as a cure all for various illnesses. If you've ever like really looked into them or you're into like antiques, you'll see some stuff.

Matthew Foreman [00:02:21]:
There's a big like collector market for, like, for snake oil and stuff like that, which is interesting. I always talk about Glengarry. Glenn Ross, great play, mediocre movie. Even though the movie has an outlandishly good cast. Fraudulent taxes to sell worthless real estate, which was swampland in Florida, but, you know, worth it. This, what used to be the Spanish prisoner now is the Nigerian prince. We've updated it. It's a tricks trickster, soliciting money from a victim for assistance helping someone of high status and great wealth.

Matthew Foreman [00:02:52]:
And always, always there's romance. Scammers built fake relationships, eventually asked for money. Historically, it was women scamming men, or at least people pretending to be women scamming men. It's flipped now, actually. A lot of women get scammed on this now. And it's much easier with online dating and meeting people on, you know, Reddit or Discord or whatever else people meet each other these days. I don't, I don't know. So the more recent ones, no, not the most current, but it's the Ponzi scheme.

Matthew Foreman [00:03:23]:
Investment fraud. Using funds for new investor investors to pay existing investors ostensibly profits or to redeem them. You know, second verse, same as the first. Charles Ponzi was not the first one to actually do this. And it wasn't the biggest. Bernie Madoff was probably the biggest Ponzi scheme, not the biggest scam. And I always wonder if Celsius was a Ponzi scheme because it, you know, if you look at it from the back end, like it kind of looked like one. Even though I actually don't think that's what they were trying to do.

Matthew Foreman [00:03:47]:
I think that's where they ended up, which is sort of interesting. There's pyramid scheme. Participants contribute money to the scheme and are offered an opportunity to make money by recruiting new members. Multi level marketing uses this and some of them are actually legitimate businesses, so it's kind of harder to tell. Ponzi sometimes looks a little more iffy. Things like that, both of them rely on really, really, really, really, really high returns. So. So if someone's saying, I'm guaranteeing you a 20% return run, that's the key.

Matthew Foreman [00:04:17]:
People say, oh, but they have, you know, this person has a history. They've done it before, you know, so did Bernie Madoff. You know, exit scheme, which is when a business suddenly vanishes with client funds. If you've ever seen the producers, that's technically, I believe, an exit scheme. The current modern one is cryptocurrency. Rug pulls. I'm going to talk about that. In, in a little bit.

Matthew Foreman [00:04:38]:
So I'm not going to go into right now, but I'll explain how that works. That's a, that's an intellectually interesting one and an into and an absolutely devastatingly awful one. So the, the current ones, what's, what's going on today? Like what are we seeing? Right, so compromised accounts, which is a fraud specialist impersonating a bank or law enforcement employees, employee self trading, which is inducing trading then blocking withdrawal. It's often done with what's called pig butchering. Pig butchering comes from the old, the old saying, you know, bulls and bears make money, pigs get butchered, so don't be a pig. It's emotional manipulation. It leads to investment. Pig butchering, I have found often comes with romance scams these, these days.

Matthew Foreman [00:05:22]:
And, and again both ways. Male, female, female, male, still don't know what anyone actually was. But sort of outlandish. But that, that's what goes on is, is people put money in and then they just can't take it out. That's the idea. Phishing, which is of course ph. Because for some reason, I'm sure there's a reason. I don't know what it is.

Matthew Foreman [00:05:41]:
It's fake links designed to steal sensitive information. There's smishing, which is SMS phishing, spear phishing, which is when you're highly targeted versus just sending a billion out and quishing. My new favorite one, which is using a QR code to get people link it and it's a bad link, etc. There's a super bowl commercial a couple years ago where they just put a QR code and it was to an Internet security company. It was like, why are you looking up QR codes on the Internet? Which is both brilliant marketing and a fairly damning indictment of how willing people are to just be like, yeah, I should, you know, look up this QR code. Mind blowing to me. There's romance scams that are false identities and exploits victims. We have to get the money out.

Matthew Foreman [00:06:25]:
Some of the romance scams are just, oh, I need 200, I need to pay my rent, I need to, I need food, whatever. Some of them are like, let's do some pig butchering. You should invest in this. It's interesting. It used to be foreign exchange trading, now it's crypto, second verse, same as the first, right? There's the fake kidnapping of faking a kidnapping to demand ransom money. Injured relative, arrested relative. I've seen ones where they're like, oh, you know, I got in a car accident and I damaged this guy's watch. And it was a, it was a Rolex and it was this.

Matthew Foreman [00:06:55]:
And like, it's really specific. There's also cryptocurrency rug pulls which are like super interesting. Super interesting. From a conceptual level. What, what they basically are is someone creates a new, a new token, a new coin. There's a difference between them. We're just gonna use word token, roll with it. And they hype it up, and they hype it up on all kinds of message, what we used to call message boards, you know, now it's Reddit, it's discords, things like that.

Matthew Foreman [00:07:22]:
And what they do is they, they do it. They start self trading between wallets they own. The price starts going up because they're buying it from themselves. Some sell themselves at a higher price. People see it, they're saying, look at this one, it's exploding. It's gonna be the new one. And then what happens is at some point they decided they make enough money, they start slowly selling to get some of the money out because it costs the money, you know, to, to create this, the, the token, and then it costs the money to do the trades. So they're slowly going through it.

Matthew Foreman [00:07:51]:
Once they made their money back and started making some money, they say, okay, they've hit a threshold where they've made enough money, then they just start selling as hard as they can. It pushes the price down, they pull the rug and they move on. Yeah, it happens. Anyway, so let's talk about tax a little before we get into get to the first music break, which is section 165 deals with this. It permits deductions for any loss sustained during the taxable year that is not compensated by insurance or otherwise. So if you get reimbursed, then you can't take a loss because you got reimbursed. 165C limits the deductions to losses incurred by in any trade of business. Losses incurred in any transaction entered into for profit.

Matthew Foreman [00:08:30]:
It's a bit of a catch all. And personal casualty losses. Personal casualty losses have been taxed differently recently. So Public Law 115 97, commonly referred to as the Tax Cuts and Jobs act, created 165H3. It disallowed unless it disallowed personal casualty losses. So the third one under 165 unless attributable to a federally declared disaster from 2018. Federally declared disaster. This was temporary.

Matthew Foreman [00:09:00]:
2018 to 2025. So what if my house burst down as a fire and I don't have insurance? Then you're in a talking head situation which either burning down the house or once in a lifetime. Congratulations, people got that reference. And I'm sorry, but it's 2026 now. Not a problem anymore. We got 165H5 is gone back to 165C3. And the answer is no. Public Law 119 21, commonly referred to as the One Big Beautiful Bill act, or as I call it, OB thrice.

Matthew Foreman [00:09:32]:
And it made 165H5 permanent. So it did allow a deduction. If a state declares a disaster, then it defined a state to include the District of Columbia. So apparently they do think it is. It also include the Commonwealth of Puerto Rico, Virgin Islands, Guam, American Samoa, and the Commonwealth of the Northern Marinara Islands, Mariana Islands. Northern Mariana Islands, not Marinara. I guess I'm hungry. It does not include New York City, which adds roughly double the population of the places listed above combined.

Matthew Foreman [00:10:03]:
So it's about the state, not the city. I don't know. I don't know if that matters. But it's, it's, it's interesting to me. I find stuff interesting. All right, so let's get some music in here and we'll talk about the definition of theft and what is deductible. Take a moment. So we are now talking about theft losses.

Matthew Foreman [00:10:42]:
The definition of a theft. Treasury 165 8D includes but it's not limited to larceny and pencil or robbery. Gives general idea. Can be more. Revenue ruling 2009 9. It covers any criminal appropriation of another's property. Includes swindling, false pretenses and other forms of guile. Like.

Matthew Foreman [00:11:00]:
Like the use of words for guile. That's a good word. Revenue Ruling 721 12. The loss resulted from taking property, which is illegal under the law state where it occurred and taking was done with criminal intent. So it doesn't actually require that it's illegal. But you know, you can't just. There's something to prevent it from being done. Edwards v.

Matthew Foreman [00:11:20]:
Bromberg, which is a Fifth Circuit case from the 50s. Theft depends on the law of the jurisdiction where it's sustained in the exact nature of the crime. So as long as it amounts to theft. So like you could have different things that are theft in Montana than in Tennessee if you feel like those states. Hope you like my previous episode. Do you need a police report? No, but you should definitely get one. Especially with a lot of my clients where crypto was stolen or there was a hack, they go to the FBI, they get a report there which is really helpful for, for a practitioner because we really don't have to verify a whole lot after that. If you were willing to swear up and down that this happened to the FBI, I am not terribly concerned about it.

Matthew Foreman [00:12:01]:
What about adverse possession? I don't think so. I'm not going to define adverse possession, but I actually don't think adverse possession is a theft loss unless it's totally taken and then you just, you have nothing left and you just take your deduction. I don't know if it really qualifies. So maybe, maybe not. Which is interesting. The timing is really important. When is it deductible? The taxpayer must prove ownership of property at issue. The theft occurred under the wall of the jurisdiction where the alleged loss occurred.

Matthew Foreman [00:12:27]:
The amount of the loss, you have to prove the amount of loss. You have to prove the date the tax were discovered, the loss. And you have to prove that no reasonable prospect of recovery exists. There's citations in there, not reading them. The timing of the loss, it has to be claimed in the year of discovery to the no earlier than the year of discovery. But it cannot be later. It must be in the year in which there is no reasonable process of recovery without regard to the year it was sustained. That's 165E.

Matthew Foreman [00:12:55]:
Reasonable prospect of recovery is determined considering all the facts and circumstances at that moment. So in two years later you say okay, well let's say one year, like I'm never getting this back. Two years later you get extra facts. You may have already taken the loss. That's okay. It's about the facts at that time. The year of discovery in which a. The question of whether you know there's reasonable process of recovery is that the year of discovery in which a reasonable person in similar circumstances would have discovered the fact of the theft loss.

Matthew Foreman [00:13:26]:
So I think that's a really important fact. The topic is actually really interesting. It's a really interesting case. Ramsey v. Ramsey, Scarlett v. Commissioner, 1974 Tax Court case. And it basically says you can't deduct any amount that exceeds the amount you can reasonably recover at that time. So if you think you'll get half of it back reasonably, you can deduct half.

Matthew Foreman [00:13:44]:
Right. And under Jepsen versus Commissioner, which is a 10 second case in 97, basically the reasonable process of recovery exists when a taxpayer has a bona fide claim, has a bona fide claim for recruitment from third parties and where there is a substantial possibility that such claims will be described in this fate in their favor. So it's a Reasonable prospect of recovery. What is a substantial possibility, right, that you could, you could recover, I don't know, 30%. I don't think it's 50, I think it's less. But I think it's important. And the amount of the loss is really important here, right? You're like, well it was worth 10 million and I lost it, so I can deduct 10 million. And no, that's not how this works.

Matthew Foreman [00:14:20]:
You deduct the basis, not the fair market value. Treasury Reg. 165, 8c. Treasury Reg. 1, 165 7b. 1 Roman at 2 and 165a cannot exceed the fair. This is also important. It cannot exceed the fair market value.

Matthew Foreman [00:14:35]:
But it's no higher, also no higher than the basis. So it's really the lower of the basis or the fair market value. So if you're something that's just decreased in value substantially, save land and you bought it for 100, but now it's worth 50 and someone steals the land from you. I don't, I don't know, whatever, we're pretending that they just stole it from you through some, some bad deal or something. I don't know. You can deduct 50 because that's the fair market value. That's all you're getting. So personally, personal casualty losses are really important because personal personal casual losses include losses from theft that are not connected with trader, business or transaction entered into profit.

Matthew Foreman [00:15:10]:
Common examples are fire, storm, shipwreck or other casualty or from theft. Helpful I guess. There is no statutory division definition of a transaction entered into for profit. I've had people who said, well is it a transaction entry into for profit or is it a business? The answer is it really doesn't matter, it's the same loss. So there's no statutory definition for a transaction. Transaction entered into for profit. You look at There's National Grocery 1938 Supreme Court case which looks at the primary profit motive. If a transaction is one that would ordinarily give rise to profits, then you can assume a profit motive.

Matthew Foreman [00:15:51]:
Weird versus Commissioner Third Circuit case from 1940. And there are five considerations to weigh. Right versus Commissioner TC Memo 2024 100. They are economic potential. Economic profit independent of tax savings deductibility or non deductibility is based upon the overall scheme, not merely the losing legs of the position. Primary primary motive matters and the objective facts were given greater weight than self serving statements and the taxpayer must have a profit have had a profit motive the time the transactions. Transactions were initiated. These, if you have Ever done any work or listen to my podcast section 183 hobby loss rules just a couple weeks ago you will learn that they are really kind of the same thing.

Matthew Foreman [00:16:31]:
That that's what we're talking about here. So I think that's important. We're going to talk about Ponzi losses because Ponzi losses are interesting. Revenue procedure 2009-20 is called a specified fraudulent arrangement. I'm not going to go that heavy into them but it's really important to note that especially with like a maid off people entered into that money, into that, into that situation not because they really cared and they weren't doing it. They were entering those money because they thought they'd make money by allowing Bertie Madoff and his co workers to invest on his behalf. Okay. They that's why.

Matthew Foreman [00:17:08]:
So there was a profit motive. So the transaction is entered into for profit. Does not matter if the scam is the scam from the start. The key is the taxpayer's intent and belief. It's important to remember that Madoff again was, was legitimate until he couldn't keep up with the magic. There's revenue ruling. There's a rev. Proc.

Matthew Foreman [00:17:23]:
2009. 20. There's rev. Proc. 2000. I'm sorry, yeah. Rev. Proc.

Matthew Foreman [00:17:28]:
2011-58 and rev. Renew ruling 2009 9. Which talk about Ponzi schemes. I'm not going to go into them because otherwise I this will be a full 30 minutes and I'm, I'm not doing that. I'm going to cut here. All right, we're going to go for some music and then I'm going to bring it on Home with worthlessness, abandonment and a few other fun, fun ones. All right, welcome back. We're Bringing it on Home.

Matthew Foreman [00:18:11]:
So, so what about other losses? Worthlessness. If an asset becomes wholly worthless during a tax year, the taxpayer may be entitled to loss deduction. Right. Equal to their basis of the asset. 166A1 requires a subjective and objective test to prove. Subjective is whether the specific taxpayer believe the property to be worthless. Echols Fifth Circuit case from 91 Objective Test is outside or observable indica of worthlessness. MCM Investment Management love that case.

Matthew Foreman [00:18:42]:
It's a TC Tax Corps memo from 2019. But what's, what's interesting about that is, is that you have to be able to prove it both subjectively and objectively that is worthless. But it's important to remember that you can't do this on personal property. This is business. This is Anything. So there's theft losses, which is what I'm talking about. But it's important to remember that largely the same standards exist, or similar ones, I guess, exist for just if something becomes worthless, right. And you must take the loss in the year, the tax year, the property becomes wholly worthless.

Matthew Foreman [00:19:12]:
Treasury regulation 1.1652. There's abandonment. So if it's worthless, you have to abandon it. You can't. You know, I get this question a lot. They're like, well, I still want to hold on to the stock. I don't want to let the company know I think it's worthless, but it's worthless. I want to take the loss and no, no, no, no.

Matthew Foreman [00:19:27]:
You can abandon property. You must abandon property when it's no longer useful and it is discarded. So when it's abandoned is when it's no longer useful and discarded. You have to irrevocably discard it. There has to be physical abandonment. Treasury regulation 1.167 a8 a4 and you have to intend to do it. You have to actually do it. And again, the loss is the basis, not the fair market value.

Matthew Foreman [00:19:50]:
The taxpayer must demonstrate the intention to abandon the asset. And an affirmative act of. Of abandonment, intent and affirmative act. You don't actually have to dispose of legal title. But you know, you might want to do it. You know that, that might be helpful if it's the kind of thing, you know, if it's a car, I don't know what you do with the car that's worthless. I've never most fortunately had that issue. I've had some cars that were close to it, but, you know, a couple thousand dollars.

Matthew Foreman [00:20:17]:
Thousand dollars. Still. Still something. I guess now we're going to kind of bring it on home with substantiating the deduction. Deduction and best practices. All right, so substantiating the deduction. The requirements. There are three elements.

Matthew Foreman [00:20:27]:
A bunch of cases that talk about it. I'm not going to cite them. But we're going back to theft, right? Occurrence of a theft, quantifiable loss and the date the owners. The taxpayer discovers the theft. You must prove ownership as well. Substantiating the basis the taxpayer has the burden to show the property was taken as well as the property's value and its base is the top. The alleged theft. The value is a little less helpful.

Matthew Foreman [00:20:50]:
I know that it's. You can't deduct more than the value. But for a lot of assets it's fairly obvious. So if you say, look like I don't know exactly what it was worth, but it was worth, you know, three, $400. My basis was $100. That's pretty obvious. I don't think you're going to fight on it. What they don't want is someone to say, I don't know what it's worth, but, you know, I should be able deduct the full $400 when it might have been, you know, the basis was.

Matthew Foreman [00:21:12]:
Was 100 when the fair market value might have been 20 bucks. So it's important to show basis. If the taxpayer can produce some testimony as to cost even an estimate, the court can use that. McNary and Cohan deals with that. There's, there's cases that deal with that, that cite Cohan. I'll talk about Cohen later. I talk about Cohen a lot. It's, it's, it's, it's a, it's a good case.

Matthew Foreman [00:21:31]:
It talks about a lot of stuff. The taxpayer is not bound by inaccuracies in a police report, but the burden becomes higher. I think that's important. If you do have a police report and it's wrong, you can get it corrected. They will correct police reports. You know, police officers are human. They do make mistakes. So it's important to understand that regarding reasonable prospect of recovery, it's important to note that, you know, if there is a reasonable prospect of recovery, you can't take the deduction.

Matthew Foreman [00:21:56]:
The existence of it is determined. An examination of all facts and circumstances at the time the determinism determination is made. The reasonableness of the prosecutor recovery is judged or analyzed at the time of the loss, not on the basis of hindsight. Okay. What really interesting case is state of Schofield, which was affirmed in part, reversed in part, but informed, affirmed where it's relevant. Here is the truck. The trustees deducted the theft loss 13 years after its occurrence. When the litigation for recovery finally terminated in failure.

Matthew Foreman [00:22:31]:
The decision to defer claiming the loss was unreasonable was. Excuse me, was reasonable when made so unreasonable. I suppose, though the viewpoint of hindsight may have made it unreasonable. So look, you might say 13 years later, but I never should have done that. That was bad. That was a mistake. I never should have litigated. I should just take in the loss.

Matthew Foreman [00:22:50]:
That doesn't matter. It's at the moment you do it, then it's done. Once the litigation is done, well, then it's really, you know, that's when you've come to that conclusion. When a taxpayer has no, excuse me, I went the wrong thing. Determine the reasonableness of the taxpayer's delay in claiming a loss deduction. The situation is reviewed as of the time the determination was originally made by the taxpayer and not at the time the tax litigation many, many years afterward. The IRS and states cannot use hindsight. They will try to.

Matthew Foreman [00:23:19]:
They'll say well why didn't you think that? And the answer is here's why. And it's not that you had to be correct. You have to be reasonable. Substantiating the deduction. Cohan v. Commissioner 39 Fed. 2nd 542nd Circuit 1930. If you've listened to this, I probably talk about this case once every four episodes.

Matthew Foreman [00:23:39]:
Probably, maybe, maybe more, maybe less. Ebbs and flows, right? So the absolute certainty is usually impossible and unnecessary and the tax authority should make the best possible approximation giving less benefit to a taxpayer whose lack of precision is self inflicted. This is a so called Cohan rule. It allows the taxpayers to rely on reasonable estimates. Okay. If there is a factual basis for, for that for relying on it and for the deduction. Certain. Look, it's used in a lot of cases and when the taxpayer is no or limited records substantiate the claims.

Matthew Foreman [00:24:15]:
The taxpayer is permitted to estimate or approximate the amounts as long as the taxpayer has a reasonable methodology for doing so. That's Humes, which affirmed Mitchell. Humes is 276 US 487. Also Robinette, which is Supreme Court case from the 40s. A lot of these cases are real old when, when records were worse. So records used to be worse. You know why we didn't have computers, couldn't have podcasts. People were putting stuff on records.

Matthew Foreman [00:24:41]:
So maybe I have to do a record cast and, and, and you know, have a vinyl drop or something. Right. So let's, let's bring it all home. Right? Best practices Document as best you can what was stolen, what was destroyed, what was lost, what was abandoned. Document when it was stolen, when it was lost, when it was destroyed, when it was abandoned. Document why you had no reasonable process of recovery and document how much you paid for it and its basis. Okay, this is all is a lot of cases that deal with this. This is still Cohen.

Matthew Foreman [00:25:13]:
Still works. Still, still makes sense. All right, so that was the 51st episode of How Tax works. I hope you learned something. I'll be back in two short weeks with the 52nd episode where I'll be discussing QSBs or why you maybe possibly should not bother. Thanks for listening. Let's go enjoy some music.