THE STASH MARCH 17, 2009
-
Read Later
READ LATERAvailable only to subscribers. SUBSCRIBE TODAY
-
Listen
ARTICLE AUDIO
- Font Size
It looks like the IRS is going to let victims of Madoff and other ponzi schemes deduct about 95 percent of their losses. Per the Times:
[T]he I.R.S. will allow investors, including those who are suing Mr. Madoff, to claim a theft-loss deduction equal to 95 percent of their investments, minus any withdrawals, reinvested gains and payouts from Securities Investor Protection Corporation, the government-chartered fund set up to help protect investors of failed brokerage firms.
As I understand it, the rule for normal capital losses is that you can deduct up to $3,000 of your net losses in any given year, but carry losses above that limit into a subsequent year and take a deduction then. (So if you had $5,000 in gains and $10,000 in losses, you could deduct $3,000 of your $5,000 net loss this year, then carry forward $2,000 in losses to offset capital gains in a future year.) I guess this would eliminate that $3,000 limit.
A knowledgable reader objects on three grounds:
1.) How is this different than investing with an incompetent money manager and getting wiped out that way? Alas, we limit deductions in that case.
2.) There's a moral hazard dimension--people will be less vigilant about avoiding Ponzi schemes and con men going forward if they know they can deduct all their losses.
3.) No one's talking about taxing 100 percent of the gains Madoff's investors made along way. (Some people did reap gains, believe it or not, though it was mostly at the expense of others, of course.)
Update: Commenter agentzero pushes back, arguing that this is how the IRS pretty much always treats "theft losses" (i.e., money or property that was stolen from you). He/she adds:
Here is what is new. If you have a theft loss in these circumstances, your deduction is the amount lost--but you cannot deduct any amount that you have a "reasonable prospect" of recovering until that prospect either pans out (in which case you haven't lost the money, so no deduction) or doesn't (in which case you get a deduction as of the time it was no longer reasonable to expect to get it back). These rules generated a considerable amount of uncertainty in the Madoff case. For example, do investors need to delay their deductions for years because there is a chance that Madoff has hidden assets somewhere that may be recovered? How will investors know when the prospect of a recovery is no longer "reasonable"?
The new IRS rules about Ponzi schemes try to clear up this gray area.
In fairness, my first reader was arguing that the Madoff losses should be treated as analogous to a capital loss rather than a theft loss. (I muddled this distinction in my explication, but I think he was clear on it.) The idea is that you willingly invested money with someone who lost it--it wasn't taken from you--and you should have to suffer the consequences. Hence the incompetent money manager analogy.
--Noam Scheiber
2 comments
Let me see if I can clear this up.
First, the IRS ruling confirmed that a Ponzi scheme loss (any Ponzi scheme; nothing in the ruling is limited to Madoff) is a "theft loss." It is not a capital loss because a capital loss is defined as a loss on the sale or exchange of a capital asset. There was no such "sale or exchange" here, any more than there is when jewelry, say, is stolen out of your house. The IRS ruling is not making law on this point, but just confirming current law. The moral hazard point is silly. I highly doubt that you leave your doors unlocked on the ground that if your possessions are stolen, your tax deduction will not be subject to the capital loss limitations.
The IRS ruling separately confirmed that certain other limitations on losses in existing law do not apply in this situation. Again, the IRS is not making law but interpreting it in the same way that advisors have generally been interpreting it since the scandal broke.
Here is what is new. If you have a theft loss in these circumstances, your deduction is the amount lost--but you cannot deduct any amount that you have a "reasonable prospect" of recovering until that prospect either pans out (in which case you haven't lost the money, so no deduction) or doesn't (in which case you get a deduction as of the time it was no longer reasonable to expect to get it back). These rules generated a considerable amount of uncertainty in the Madoff case. For example, do investors need to delay their deductions for years because there is a chance that Madoff has hidden assets somewhere that may be recovered? How will investors know when the prospect of a recovery is no longer "reasonable"?
The IRS decided to deal with this by establishing a rule of thumb that 95% of a Ponzi scheme loss is considered lost in the year the scheme is discovered. (If you have a third party you can sue, such as the fund of funds manager who didn't do due diligence and put you into Madoff, your presumed percentage in the year of discovery is only 75%). If you end up losing only, say, 80% of your money, you will have to report the difference between 80% and 95% as taxable income when you get it. If you lose 100%, you can claim a deduction for the additional 5% when it becomes clear you are going to lose it.
Finally, it should be noted that the IRS generally is NOT allowing investors to go back to the years in which they reported what they thought were Madoff profits and amend their returns to take the profits out on the grounds they never existed. Instead, if you reported and paid tax on $100 of purported Madoff profits five years ago, but you left the $100 in your account and never withdrew it, that $100 is included in the amount of your investment that you can claim as a theft loss--in other words, you are treated as if you really received the $100 five years ago and it was stolen from you in 2008.
- agentzero
March 17, 2009 at 8:44pm
"How is this different than investing with an incompetent money manager and getting wiped out that way? Alas, we limit deductions in that case."
Well, one way this is different is that for years, in many cases for more than a decade, Madoff's victims have been paying taxes on the fictitious gains reported on Madoff's fraudulent statements. One victim I heard interviewed said that the IRS has been the single biggest beneficiary of Madoff's fraud, and this is likely true. Cash payed into Madoff over the duration of his fraud totals about $17 billion. Thus the $65 billion figure that's being bandied about includes $38 billion of hot air--taxed at, what, 40%?
- aeromonas
March 17, 2009 at 10:29pm