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.

The Tax-Saving Specifics

According to IRS Revenue Ruling 2009-9 and IRS Revenue Procedure 2009-20, the ordinary loss from a Ponzi investment scheme can be written off as an itemized deduction (on Schedule A of Form 1040) with the following favorable results:

* It can be deducted in full without regard to the limitations that apply to garden-variety personal theft losses.

* It can be deducted in full without regard to other rules that reduce write-offs for other types of itemized deductions.

* It can be deducted in full under the alternative minimum tax (AMT) rules.

* It can be deducted on Form 1040 for the year in which you discover the loss. However, the loss must be reduced by claims for reimbursement for which you have a reasonable prospect of recovery.

* A hefty loss can create a net operating loss that you can carry back to the three previous years or forward to the next 20 years. Even better, a special rule allows you to carry back a net operating loss created by a 2008 Ponzi loss for up to five years (vs. the normal three years).

* You can deduct a safe-harbor loss amount on the return for the year that the loss is discovered. The IRS will allow the safe-harbor loss with no questions asked, thus preventing lengthy and expensive disputes about the amount and timing of losses. Just keep in mind that the safe-harbor privilege is only allowed for losses discovered after 2007.

Safe-Harbor Loss Deduction Rules

Depending on whether or not you can potentially recover some of your loss from certain third parties, the safe-harbor loss deduction amount is based on either 95% or 75% of your qualified investment (initial investment + subsequent investments + related income reported on your tax returns for earlier years withdrawals). You must then reduce the 95% or 75% amount by any actual recoveries that you ve collected by the end of the year in which you discover the loss and by any estimated future recoveries from certain sources (such as SIPC insurance). The end result is your allowable safe-harbor loss deduction for the year in which you discover the loss. You must also take the steps specified in IRS Revenue Procedure 2009-20, which include filing a properly completed Form 4864 (Casualties and Thefts) with the return for the year you discover the loss and attaching a safe-harbor loss deduction worksheet. Getting professional help to meet these requirements might be a good idea.

Finally, if you eventually recover less money than you estimated when calculating the safe-harbor loss amount, you ll be allowed to deduct the difference in the future. If you recover more than expected, you must report the difference as taxable income in the future.