Tax Update Blog: Permalink
« Previous · Tax Update Blog Home · Next »
Theft losses for Madoff victims?
December 17, 2008
See Update below
Now that Bernard Madoff's spectacular $50 billion Ponzi scheme has blown up, his victims will pick up the pieces where they can. One logical place to look is in the theft loss rules of the tax law. A recent New York Times piece explains the rules (hat tip: Tax Policy Blog):
Under the rules, investors can deduct their losses against 90 percent, and in some cases all, of their adjusted gross income. So an investor who lost $1 million to Mr. Madoff and whose adjusted gross income is $600,000 can claim a tax loss of $939,900. That is the result of $1 million reduced by 10 percent of the adjusted gross income, and minus a $100 fee that is applicable under I.R.S. rules, according to Robert Willens, a tax and accounting authority who provided the example. (Ed: But see update below)
The Times piece unfortunately has some misleading information:
The rules permit losses stemming from theft to be deducted in the year in which the loss is discovered by the investor. They also allow investors to carry back such losses for three years — one more year than under the rules for capital losses — and to carry forward losses for 20 years. Investors must compute losses according to the adjusted basis in their investment, not the fair-market value.
The three-year carryback only applies if the theft loss generates a net operating loss. You have to wipe out all of your income, including income otherwise taxed in lower brackets or protected by the personal exemption, before you have a net operating loss. The three-year period is a year longer than the normal NOL carryback period for non-theft losses; capital losses cannot be carried back by individuals, and they are only deductible to the extent of capital gains, plus $3,000.
The Tax Lawyer's Blog highlights another potential problem for the Madoff victims:
The Times article fails to point out that Madoff was arrested on December 12, 2008, and has not yet been adjudicated guilty of investor fraud. It is therefore likely that the IRS will deny a 2008 theft loss deduction on the grounds that it has not yet been determined that a theft has in fact occurred. This means that the investors will not be able to claim their theft losses until both Madoff is adjudicated guilty and there is no reasonable expectation of recovery of the lost funds.
These are true potential issues, but I don't expect the IRS to be so strict. It seems pretty clear that a theft has occurred. It also seems unlikely that there will be much recovery. The tax law doesn't require a conviction before a loss may be claimed. Not least, Madoff has a lot of victims, which means the IRS has an interest in streamlining the process for its own management purposes; and the victims include many prominent taxpayers, so the IRS will face pressure not to be jerks.
While you shouldn't file your return based on what the Tax Update thinks is likely, I would not be surprised to see the IRS allow deductions of the full account balances (actually, cost basis) in 2008, with any recovery taken back into income when received, if ever. If the IRS takes a public position, we'll post it.
Link: IRS Publication 547, Casualties, Disasters and Thefts
UPDATE, 3/17/2009: The IRS has issued a safe-harbor revenue procedure and a revenue ruling that look to be taxpayer-friendly. They allow a deduction in 2008 for up to 95% of the investment, and the deduction won't be subject to the 10% casualty loss haircut.
Bookmark: del.icio.us • Digg • reddit
Tax Updates
Subscribe to Tax Updates
The items included in the Tax Update Blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation.
Joe Kristan writes the Tax Update items, and any opinions expressed or implied are not neccesarily shared by anyone else at Roth & Company, P.C. Address questions or comments on Tax Updates to
Search Tax Updates
Friends and Neighbors
Economics Nerds
Hard-Core Tax Nerds
Gigablogs
Insurance Folk
Goners
Legislation
Tax Update Data Feeds
Comments
Joe,
In the typical theft loss case it is tangible property that is stolen from a house or a car. We know a theft has occurred, we just don't know who did it. In that instance, yes, a theft loss can be claimed without a conviction.
But in the case of white collar crimes like investor fraud, the situation is reversed. We know who did it, but we don't know if it was theft. A conviction or an admission of guilt is necessary to determine whether or not the loss is merely a capital loss or an actual theft loss.
I agree that a loss has occurred, but will the IRS concede that it was theft if Madoff is putting forth a defense that says he did not intend to steal from anyone?
What if Madoff is acquitted? Is it still a "theft" loss?
And if so, would an investor be required to amend their returns to correct the treatement from a theft to a capital loss?
The IRS scrutinizes investment losses categorized as theft more closely than it does the typical, tangible property theft case.
I have a client who was a victim of a cash4title ponzi scheme in 1999. He filed his return very late and claimed a theft loss based on the promoter's conviction. The IRS auditor disallowed the theft loss on the basis that we had not proven that the loss was unrecoverable even though the taxpayer had 8 years to recover the loss and was unable to do so.
Fortunately, we went to Tax Court and were able to win it on appeal.
Posted by: peter | December 17, 2008 11:34 AM
Peter - all excellent points, and I would expect all of these problems to arise for victims of a Ponzi scheme affecting only the little people. This affects big shots, so the IRS is more likely to be shy.
Also, Madoff has admitted it was a Ponzi scheme; that's how the thing came out. I don't think a guilty plea is required (even if an IRS agent were to try to say so). But mostly I just think the politics of the thing will move the IRS to back off.
Posted by: Joe Kristan | December 17, 2008 5:39 PM
I agree that it isn't in the IRS best interest to deny the loss. However, it will be a long time before they are able to unravel how much of each investors loss was attributable to theft and how much was just lost in the market. I think the IRS is going to stand firm on the idea that some of these losses are capital losses and not theft losses.
I am still reeling at the incompetence of the SEC auditors.
Posted by: Jan Dillaha | December 17, 2008 9:10 PM
Not to be nit picky, but can we put some responsibility back on the investors. Not all of the people that gave Mr Madoff were victims. Some of them had the ability to understand that these sorts of returns couldn't be real.
Posted by: Jan Dillaha | December 17, 2008 9:14 PM
Regarding a theft loss claim, is the loss limited only to the actual money invested into Madoff or does it include the total amount listed on the final monthly brokerage statement (presumably the Nov 08 statement)? If it is only the amount invested, do redemptions have to be considered in determining the theft loss?
In the NY Times article, it says in some situations that all of the loss, not just in excess of 10% of agi, may be claimed - what makes the full loss available?
Lastly, for those who invested directly into Madoff, is there any reason why they should not be eligible for SIPC coverage?
Its a very trying time for those who have been victimized, and the uncertainty of how it all will play out compounds the problem.
Thanks
Posted by: Jason | December 20, 2008 11:46 AM
Theft losses are suddenly 95%-deductible in full as tax credits, whereas before, only $3000 over net capital gains was deductible each year (and taxes paid on phantom income were not recoupable either). Is this correct? If so, funny how the rules changed when the influential were publicly involved.
Posted by: Barry | March 20, 2009 11:22 PM