Fraud victims hit by 'double whammy' of theft, taxes on stolen funds

As fraud targeting older adults and other victims rises by several billion dollars each year, those suffering losses are more likely to be taxed on the stolen income.

The Tax Cuts and Jobs Act of 2017 changed the casualty and theft loss tax deduction to apply solely to costs related to federal-designated disasters. Previous guidelines had allowed for a fraud-related deduction. That drastically reduced fraud victims' claims in recent years, according to a report earlier this spring by Democrats on the U.S. Senate Special Committee on Aging. 

Beyond the rules shift for that deduction, many of the hundreds of thousands of Americans defrauded annually come to the unfortunate realization that they could get hit with higher tax bills thanks to penalties for the withdrawals from or liquidation of their retirement accounts, according to elder fraud expert Paul Greenwood of Greenwood Law.

"The times that I have heard victims tell me about this double whammy is when they have been liquidating their IRAs and don't understand that early withdrawal or surrender of these investments triggers some IRS liability," he said in an interview. "Not only should brokers be warning them about tax liabilities but also saying, 'This is very unusual,' and then really press them on, what is the reason for your wanting to liquidate today? What is the emergency? I wish brokers and banks would be far more specific in the questioning of the customer."

READ MORE: How advisors can help older clients recover from scams

Lawmakers likely made the adjustment, limiting the deduction to federal disaster areas through 2025, as a "pay-for" provision in the legislation, which also reduced the potential audit work of the IRS and had "nothing to do in particular with going after these victims," said Patrick Thomas. A managing associate with the Frost Brown Todd law firm, Thomas wrote a letter included in the Senate committee's report. Taxpayers may still qualify for a deduction based on their losses — but only if they were seeking investment or business profits, not if they fell victim to other common scams like those involving technology support, email compromise or romance, he said.

"Ultimately it is the intent of the taxpayer in investing or in transmitting the money to the scammer that determines whether it could fall under a subsection of the Internal Revenue Code that allows for deductibility even post-TCJA," Thomas said. "If there is an investment motive or a profit motive, then the ability to deduct I think is much more likely under the law."

Unfortunately, more taxpayers could find themselves asking financial advisors or tax professionals how to cope with fraud losses. 

Last year, a record 880,418 complaints reported losses of more than $12.5 billion, the FBI reported last month in its annual Internet Crime Complaint Center report. In the past five years, the number of complaints has nearly doubled, while the losses are 3.5 times as high as in 2019. Among Americans who are at least 60 years old, the losses soared to $3.4 billion in 2023 — more than six times as much as in 2019.

READ MORE: The vital role of financial advisors in stopping fraud and elder abuse

The Tax Cuts and Jobs Act sharply reduced itemization of all kinds because the legislation doubled the standard deduction, but Thomas, Greenwood and other fraud experts argue the language about the casualty and theft deduction accounted for at least some of the decline in claims filed by taxpayers with the IRS. In 2017, 113,378 claims sought $2.8 billion worth of disaster and fraud-related deductions, according to the Senate report, which the office of Sen. Bob Casey of Pennsylvania, the committee chair, released in April. By 2021, the latest year with available data from the IRS, the claims had tumbled to 10,137 households seeking $726 million.

"Congress ought to be protecting victims of fraud and scams — not adding insult to injury by forcing them to pay taxes on their stolen savings to offset fat cat tax breaks," Casey said in a statement. "I hope the devastation unveiled in this report helps ensure that we never make these mistakes again and instead use the tax code to uplift working families and those in need."

Casey and other lawmakers have introduced bills that provide greater eligibility for the deduction to defrauded taxpayers — an idea that has drawn support from the AARP, among other advocates. In a March letter to the four Democrats and one Republican cosponsors of one of the bills, the organization shared quotes from an AARP online group support forum and several stories from fraud victims discussing the added tax burden after sustaining scam-related losses.

"Victims of fraud are often shocked to learn of the tax liabilities they face associated with their losses," AARP Senior Vice President of Government Affairs Bill Sweeney wrote. "For example, if a victim withdraws funds from a tax-preferred account to invest in something that they later learn is a scam or gives someone money who they later learned was a criminal, those lost funds are treated as income and taxed accordingly. They no longer have their investment; the criminal has made off with their money — and now they owe taxes on those funds. These victims have already suffered grave financial and emotional harm; to owe taxes on financial assets they have lost to criminals is viewed by many as a double injury."

READ MORE: The disturbing size of elder financial abuse in America

Another tax-related complication, in addition to the underlying fraud, can arise because of a gap between when the victim lost the assets and when they report it to the IRS — which can't happen until they recognize the scam, Thomas pointed out. Tax laws deem thefts to occur "in the year in which the taxpayer discovers the loss," he said, recalling the story of a client of his who lost $800,000 to a cryptocurrency scam.

"In my client's case it was $800,000 out the door, and the account was pretty much drained," Thomas said. "You have an $800,000 loss, but you can't really use it unless you have other income, and if you wipe out your defined-contribution account, then that's not really helpful."

Though fraud has seen disturbing levels of growth, the problem could actually be underreported because there is "such a shame associated with being a victim in this way," Thomas added.

Greenwood agreed that actual fraud losses are "probably far higher," he said, suggesting advisors or relatives of older adults write a letter to their client or loved one's bank asking the institution to report any unusual activity immediately to a local adult protective services agency. That could also help make it more difficult for the institution to defend a negligence lawsuit in the event of losses, Greenwood said.

"I know there is this feeling amongst a lot of people, 'Well, it's your own stupid fault and therefore you shouldn't get the benefit of deducting it as a loss,'" he said. "A genuine victim should be allowed to present their scenario and be considered for a tax deduction."