Tax Write-Off for Madoff Victims

Can victims of the Bernie Madoff Ponzi scheme take a tax write-off?

Yes, the Madoff victims can take a theft deduction for their losses, and the IRS recently issued special rules explaining how to do this.

The IRS said that losses from Ponzi schemes are considered to be theft losses rather than capital losses, which gives taxpayers a more valuable deduction. Most stock-market losses are considered to be capital losses, which you first subtract from capital gains. After doing that you can subtract up to $3,000 in excess losses from income; any additional losses are carried over to future years. But theft losses from the Madoff Ponzi scheme (and other Ponzi schemes) are reported as an itemized deduction. They offset any kind of income and there’s no $3,000 annual limit. In fact, if your loss more than offsets all of your 2008 income, you can use the excess loss to retrieve taxes paid during the previous five years.

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Other types of theft losses are deductible only to the extent that they exceed 10% of your adjusted gross income. However, the IRS specified that Ponzi-scheme deductions are not hit by the reduction.

The IRS made clear that people who invested directly with Madoff can report the losses on their 2008 tax returns -- even though they may have invested the money over a long period and paid taxes on phantom gains throughout the years -- rather than file amended returns for those previous years, says Richard Goldstein, chairman of the tax department at Bilzin Sumberg, in Miami, Fla. The rules are a bit different for people who invested in Madoff's scheme indirectly through other firms, known as feeder funds.

Normally, before reporting a theft loss you must estimate how much money you will recover. But that may take a while in the Madoff case, so the IRS eased the rules to let most people deduct 95% of their initial investments with Madoff, plus any income from the Madoff fund that they've paid taxes on through the years, minus any withdrawals and minus any money they expect to receive from the Securities Investor Protection Corp. People who are suing their brokers, financial planners or other third parties in addition to Madoff can deduct 75% rather than 95% of this amount.

The deductible theft loss should be entered on line 34, Section B, Part 1 of Form 4684, says Mark Luscombe, principal tax analyst with CCH, a tax-publishing firm. It's then reported on Schedule A as an itemized deduction. The IRS explains the rules in a Revenue Procedure, which includes a worksheet in Appendix A to help you calculate the eligible theft loss. The IRS also clarified some of the rules in a new Revenue Ruling. For more information about the rules, see IRS Commissioner Doug Schulman's testimony to Congress about tax issues related to Ponzi schemes.