Scammed in 2008? Get Some Money Back from the IRS

by Kathy M. Kristof | Mar 5, 2009 | Comments

Key Stats

• Ponzi schemes: Date back to the early 1900s, but those discovered in the past few months are among the biggest ever.
• Recent damages: Bernie Madoff, $50 billion; R. Allen Stanford, $8 billion; Paul Greenwood and Stephen Walsh, $554 million; Arthur Nadel, $300 million (according to the SEC).
• Tax implications: U.S. tax laws let you write off theft losses.
• IRS information: Topic 515 — Casualty, Disaster, and Theft Losses explains the government’s rules.

If any of your money disappeared down the rathole known as Bernie Madoff — or any of the similar Ponzi operations that came to light last year — the IRS offers some relief, if not much sympathy. You may be able to get back some of the lost cash through tax write-offs on your 2008 return. You might even be able to write off taxes on previous returns, since you may have paid tax on fake gains for years. But there’s no agreed-upon way to claim these losses — even though the IRS recently announced its recommendations for Madoff-fleeced taxpayers. “The IRS has come up with an easy answer, but it is not necessarily the best answer for everyone,” says Robert A. Friedman, a partner at the New York law firm Troutman Sanders. So if you were scammed by Madoff, you’ll need to do a little math to come up with the approach that’s best for you.

There are actually three ways to take losses. One has the approval of the IRS but may not be best for you. The other two won’t make you any friends at the IRS but have had some success in the U.S. Tax Court.

Option 1: Wait It Out

Bernie Madoff's fleeced investors can choose among three ways of claiming their tax losses.(AP/Stuart Ramson)

The way the IRS likes to approach theft losses is to have taxpayers claim a loss in the year the theft was discovered and when the amount can be quantified. “It’s pretty clear that the loss was discovered in December 2008, when Madoff confessed,” Friedman says. But the size of each investor’s loss may not be clear yet, because victims have legal claims against Madoff’s assets. Some investors also have claims either against the intermediary who told them to invest with Madoff or against an insurance company or guaranty fund.

Theoretically, you’re supposed to wait to claim the loss until you can figure out how much, if anything, you’re due. That typically takes years. On the bright side, any profits you paid tax on in previous years would be added to your investment cost, increasing the value of the loss when you finally do make the claim. In other words, if you invested $100,000 and paid tax on $10,000 in annual gains for the past 10 years, your loss would be $200,000.

However, the IRS just came out with special rules for Madoff investors. If you’re not taking someone to court over your Madoff mess, you will be allowed to claim 95 percent of your investment as a loss on your ’08 tax return — after deducting any recovery you might receive from the Securities Investor Protection Corporation. You can write off 75 percent (minus potential SIPC recoveries) if you’re pursuing legal claims. People following this approach must include with their return a statement about their Ponzi losses.

Option 2: Fix Past Mistakes

Another approach is to amend previous tax returns to back out Madoff-related profits, saying they were mischaracterized and were actually a return of principal. After subtracting the return of principal, you’d claim the remaining losses as theft losses. This approach has the benefit of logic: Anyone who’s familiar with Ponzi schemes knows that if you got money back, it was your (or someone else’s) principal. It also lets you recover a portion of your tax overpayments fairly quickly. Taxes remain open for three years following filing, so in the previous example, you could claim $30,000 of overstated profits: $10,000 on your 2005 return, $10,000 for 2006, and $10,000 for 2007. Since Madoff’s fiction was that he earned this money on short-swing trading, you probably paid ordinary income tax rates on it. Assuming a 35 percent marginal tax bracket, this claim would get you back about $10,500.

This approach creates a bookkeeping nightmare for the IRS, though, and the agency has frowned on it in the past. But the Tax Court has sometimes sided with taxpayers who chose this option. “I would advise people to consider filing claims to back out the income for these open years and then perhaps claim a theft loss on their 2008 return,” says Philip J. Holthouse, a partner with Holthouse Carlin & Van Trigt, a tax law and accounting firm based in Santa Monica, Calif. If you amend those returns soon, you’ll preserve your legal right to claim that’s how you ought to recover your Ponzi losses. If you wait, the tax years will close and you’ll lose your chance.

Option 3: Claim It All Now

In this approach (the most immediately lucrative), you tell the IRS that every dollar you invested with Madoff was lost, as were the fake profits you paid tax on. In the unlikely event you recover any of these losses, you’ll pay tax on them at that time.

This strategy would let you write off all of your Ponzi losses on your 2008 return. “If the theft losses exceed your 2008 income, they become net operating losses,” Holthouse says. That means they can be carried back three years to recapture taxes paid in the past. And if you have still more losses, they can be carried forward 20 years. “Some victims may never pay taxes again,” he says.