Tax Breaks for Ponzi-Scheme Victims

If you've been cheated in a Ponzi investment scheme a la Bernie Madoff, the IRS wants to cut you some slack. The feds will let you treat your loss as a tax-favored ordinary loss rather than a capital loss.

Here’s what you need to know.

Capital Losses (Bad) Vs. Ordinary Losses (Good)

The IRS generally takes a dim view of taxpayer attempts to treat investment securities losses as anything other than capital losses. Capital losses fare poorly under our beloved federal income tax system. You can only deduct them to the extent of capital gains for the year, plus another $3,000 ($1,500 if you use married filing separate status). Any leftover capital losses get carried forward to the following year, and the same limitation rule applies all over again.

As a result, it can take years to fully deduct big capital losses.

In contrast, ordinary losses are treated quite well. They can be written off against any type of income (salary, interest, dividends, capital gains, self-employment income, you name it). If you have a big ordinary loss that exceeds what you can deduct in the loss year, the excess can potentially create a net operating loss. You can carry a net operating loss back to previous years and recover taxes you paid earlier, or you can carry it forward to shelter income in future years, which will be especially helpful if tax rates go up.

Ordinary Loss Treatment for Ponzi-Scheme Victims

The IRS has announced it will allow favorable ordinary loss treatment for investment theft losses. Basically, such losses occur when your money is never actually used for the intended purpose of acquiring investment assets.

Instead, the money is hijacked by the perpetrator of a fraud. The classic example is the so-called Ponzi scheme where money collected from later “investors” is used to cover “income distributions” and “withdrawals” paid to earlier “investors” without any investments ever actually being made.

Taxpayer-friendly ordinary loss treatment takes some of the sting out of Ponzi scheme losses. Unfortunately, however, there are plenty of victims who can benefit from the IRS's enlightened attitude. Not only did Bernie Madoff lose some $65 billion of investors' money, but other similar frauds have since come to light. The sad truth is, Ponzi losses are more widespread than you might think.