Do Madoff Victims Deserve Extra Tax Deductions?

by Noam Scheiber | March 17, 2009

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

Source URL: http://www.newrepublic.com//blog/the-stash/do-madoff-victims-deserve-extra-tax-deductions