Get your Madoff deduction here!

By Jeff Schnepper

Oh, the shame!

Oh, the pain!

And you had to be part of the gilded inner circle to get gelded in the Bernie Madoff scam.

Luckily, the Internal Revenue Service is going to help you out. I kid not.

IRS Commissioner Douglas H. Shulman told the Senate Finance Committee on Tuesday that it will allow victims of Madoff's investment fraud to claim a tax deduction on their losses.

The IRS will let investors in investment frauds, including the Madoff scam, claim a theft-loss deduction equal to 95% of their investments in the scams, less withdrawals, reinvested gains or payouts from the Securities Investor Protection Corp.

Investors who are suing third-parties involved in the scheme, such as financial advisers, and who may have some prospect of recovery, can claim a deduction equal to 75% of their investments.

At the same time, three more provisions of the decision will ease the pain.

• Normally, in claiming a theft-loss deduction, you would have to reduce your loss by $100. But because people put money into Madoff (or a similar scam artist) with the hope of earning a profit, that provision is waived.

• You also don't have to reduce your loss by 10% of your adjusted gross income.

• You can carry back net operating losses five years to offset taxes paid, or forward 20 years.

In December, Madoff, the supposed financial guru, confessed to running a huge Ponzi scheme. At the time, it was estimated at $50 billion; it may have been as big as $65 billion.

A Ponzi scheme is so-called because initial investors are paid "returns" out of money subsequent investors have contributed. They, in turn, are paid with dollars from new investors. It's nothing more than a giant pyramid scheme destined to crash. There are no earnings or profits, just transaction fees pocketed by Madoff.

You couldn't just give Madoff money to invest. To be a Madoff mark, you had to know somebody on the inside. It was an exclusive club with more money than financial brains. If you dared ask Madoff where the income was coming from, you were banned from the inner circle and couldn't invest.

• For more on the Madoff case, play the videos to the right.

Those who weren't banned included "Today Show" co-anchor Matt Lauer; industrialist Ronald Perelman; singer Rod Stewart; actor Kevin Bacon and his actress wife, Kyra Sedgwick; Sen. Frank Lautenberg, D-N.J.; New York Mets owner Fred Wilpon; real-estate developer Mortimer Zuckerman; film director Steven Spielberg; and Nobel laureate Elie Wiesel.

Some salve for the pain

Billions of dollars from charitable foundations disappeared. Because they are (or were) tax-exempt organizations, there's little to help the hurt.

But individual taxpayers will get a break, and I'm pleased that the IRS agreed with me (and others in my business) on how treat the losses.

Under the old rules, if you invested in a Madoff fund that now has no value (or a fund run by a growing number of promoters charged with running Ponzi schemes), the conventional wisdom was that you get to deduct a short-term capital loss for your worthless investment.

That offered a complicated and not useful solution. You first had to prove the investment worthless.

And then your capital loss could be taken only against any capital gains -- in 2008, that pretty much limited you to McDonald's (MCD, news, msgs) and Wal-Mart Stores (WMT, news, msgs) -- and $3,000 per year to offset ordinary income. So, without any capital gains, it would take you more than 30 years to get the benefit of a $100,000 loss.

Worse yet, if the Madoff investment was in a retirement account such as an IRA or 401(k), the loss would not be deductible. You'd just have less income to report because you'd have less income to withdraw.

The tax code actually provides the solution

When I started to think about the problem, I thought it was possible to claim a theft loss.

Financial fraud is included under the U.S. Tax Code's definition of a theft loss. Madoff's conduct clearly falls under the ambit of financial fraud. Madoff has confessed in court that his investment business was a big lie. He pleaded guilty to 11 fraud counts last week.

Now there's talk the government may seize all his assets, listed at $826 million in December.

What's good about being able to claim a theft loss is that nearly all your loss would be deductible in the year of the discovery -- 2008 in this case.

You will should claim the loss on Form 4684 and Schedule A (.pdf files).

Continued: The IRS really had no choice

 1 | 2 | next >