What the Tax Code Says About Your Losses

Scammed in a Crypto Scheme?

By Sean Wandrei

Have you received a text lately from strangers who think they know you or want to be your friend? I have been receiving those for a while now. I thought I was popular, and these people wanted to be my friend. Maybe a few of them want to be, but many of these texts are from people looking to find their next target.

‘Pig butchering’ has become increasingly prevalent in recent years. That’s the term for a scam that deceives individuals into giving up money under false pretenses. The scammer fattens the victim, the ‘pig,’ by slowly guiding them into making increasingly large investments before disappearing with the victim’s money. These schemes can be presented as an opportunity to help someone out, find love, or take advantage of an incredible investment opportunity. With the boom in the cryptocurrency market, many of these schemes involve investments in crypto.

The scammer gradually builds trust with the victim over time. Once the trust is built, the scammer tells the victim about a great investment opportunity where they made a lot of money from investments, or how they need money for other reasons. The scammer may show the victim evidence of investment gains.

Sean Wandrei

“The key difference between these two situations is the victim’s intent — if the individual engaged in the transaction with the expectations of earning income or capital gains, then the loss suffered can be treated as an investment loss rather than a personal expense.”

Eventually, the victim is guided to a website or app to invest in crypto. The app could look like a platform such as Coinbase. The platform is set up by the scammer, and eventually the victim’s crypto is transferred off the platform and gone forever. Or the crypto never existed — the money the victim sent simply went into the scammer’s account.

Deducting Losses from the Scam

Internal Revenue Code (IRC) Section 165 provides the taxpayer with an opportunity to deduct losses incurred from various transactions, subject to specific rules and limitations. The deductibility of losses suffered from fraudulent schemes depends significantly on the nature of the transaction and the taxpayer’s motive at the time of the transaction. Two distinct scenarios arise in the context of pig-butchering schemes: losses incurred from transactions driven by personal motives (helping someone out or looking for love) and losses incurred from a transaction entered into for a profit (investing in crypto).

When a loss is incurred because an individual gives money to help someone out or in the pursuit of a romantic relationship, the transaction is typically characterized as a personal expense. These losses could be seen as a theft loss arising from non-business, personal transactions. Under IRC 165(c)(3), theft losses generally are not deductible due to the Tax Cuts and Jobs Act, which limited the deductibility of personal casualty and theft losses to those incurred in a federally declared disaster area.

In this context, the taxpayer’s motive was not profit-driven, but rather a personal connection or desire to help, which means this loss would be a theft loss and not deductible. The rationale is that the tax code does not provide relief for personal financial mistakes or misguided generosity when they lead to fraud.

Contrast this with the scenario where the pig-butchering scheme is one where the victim believes that they are investing in an asset such as crypto. In this case, the victim’s primary motive is to earn a profit by investing in crypto. Under IRC 165(c)(2), losses incurred from transactions entered into for profit, which are not connected to a trade or business, are deductible.

The key difference between these two situations is the victim’s intent — if the individual engaged in the transaction with the expectations of earning income or capital gains, then the loss suffered can be treated as an investment loss rather than a personal expense. The IRS treats crypto as property, so a case can be made that the victim was investing in property with a profit motive of investment income.

If the victim is going to deduct the loss under IRC 165(c)(2), he or she must adhere to substantiation requirements. Detailed records of the transaction, evidence of the profit motive, and clear documentation of the loss are necessary to support any deduction claimed on the tax return.

For example, consider a taxpayer who entered into a crypto scheme that ultimately turns out to be a pig-butchering scheme. If the taxpayer entered the transaction with a clear profit motive, expecting to realize gains from a booming cryptocurrency market, the loss from the scheme can be characterized as an investment loss. This categorization aligns with the general principle that taxpayers are allowed to deduct losses on investments when those losses result from a transaction entered into for profit.

Bottom Line

There is little case law on this subject, as it is relatively new. To deduct these losses, a taxpayer must maintain clear documentation of all interactions with the scammer, deposit dates, and evidence of profit motive.

Falling victim to these scams can have major financial consequences for the victim and his or her family. The monetary loss could be alleviated by deducting the loss and reducing the taxpayer’s tax liability. As mentioned above, there is limited tax precedent on this subject, so taxpayers should contact a tax professional to ensure the claim is legally sound and in full compliance with current laws.

Sean Wandrei, CPA, MST is a senior lecturer in the Department of Accounting at Isenberg School of Management at UMass Amherst.