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Friday, December 19, 2008

New York Times: Tax Rules for Theft Losses Could Help Some Investors

By LYNNLEY BROWNING
Published: December 18, 2008

For the legions of investors who appear to have been swindled by Bernard L. Madoff, there could be some relief.

Tax rules allow investors who fall prey to criminal theft perpetrated by their investment advisers or brokers to claim a tax deduction stemming from their losses.

The rules, which are intended to aid investors cheated through embezzlement, pyramid schemes, extortion or robbery, could potentially put hundreds of millions or even billions of dollars back into the pockets of Mr. Madoff’s stunned investors. They include the publishing magnate Mort Zuckerman; the owner of the New York Mets, Fred Wilpon; a foundation run by the filmmaker Steven Spielberg; and wealthy clients and banks from Palm Beach to Switzerland.

But it is unclear whether the Internal Revenue Service will see things that way. “We are aware of the situation, but beyond that, we have no comment,” Bruce Friedland, an I.R.S. spokesman, said on Thursday.

Gary A. Zwick, a tax lawyer at Walter & Haverfield in Cleveland, said, “It’s fair to say that many people will take the position that the theft loss rules will apply, but the government may not take that approach.”

Investors who can prove they were cheated may also be able to claim a refund for federal taxes paid over the last two years on “phantom” interest income from their investments with Mr. Madoff. But they cannot claim a refund for taxes paid on any capital paid back to them. Mr. Madoff, who was arrested last Thursday, ran what prosecutors contend is history’s largest Ponzi scheme.

On the tax front, a formal declaration that Mr. Madoff’s investment funds are bankrupt would help investors. “Embezzlement followed by bankruptcy is a pretty good indication that you’re not going to get your money back and will have a theft-loss claim,” said D. Matthew Richardson, a tax lawyer at Sheppard Mullin Richter & Hampton in Los Angeles. Mr. Madoff’s firm, Bernard L. Madoff Investment Securities, is currently being liquidated by a court-appointed trustee.

But before investors can claim the deduction, they have to clear a tall hurdle: they have to be reasonably certain that they will not recover their money. Proving that could take years, as investigators and regulators pore over Mr. Madoff’s books and a wave of lawsuits emerges.

It is unknown whether Mr. Madoff used investors’ money not just to pay early investors but also to stash in his personal bank accounts overseas or to underwrite a lavish lifestyle. Any such assets, as well as insurance, could be a source of recovery for investors — and could dilute any tax write-offs. The charities that fell victim to Mr. Madoff would not be eligible for any relief because they are exempt from taxes.

“I think it’s 100 percent certain that investors will get the theft-loss deduction, but nobody’s going to get it right away, and it may take five years,” said Alvin Brown, a tax lawyer and former manager in the I.R.S.’s chief of legal department.

Under theft-loss rules, investors can generally deduct 90 percent of their losses against their adjusted gross income, according to Robert Willens, a tax and accounting authority. Investors who argue that the loss arose from a for-profit transaction — the point of investing — may be able to deduct 100 percent. “Investors in programs sponsored by Mr. Bernard Madoff may find that their losses will be mitigated by certain ameliorative provisions of the tax code,” Mr. Willens said.

The rules permit losses stemming from theft to be deducted in the year in which the loss is discovered by the investor, even if it took place earlier. They also allow investors to carry back theft-losses for three years — one more year than under the rules for capital losses — and to carry losses forward for 20 years. Investors compute losses according to the adjusted basis in their investment, not the current fair-market value.

The theft-loss deduction is not the same as the more commonly used capital loss deduction, which applies to securities that decline in value.

In 2006, the I.R.S. processed more than 206,000 claims for theft-loss and casualty deductions — the I.R.S. groups the two — worth more than $5.1 billion. Claims filed under the Madoff scheme would most likely dwarf that dollar figure.

Copyright 2008 The New York Times Company. All rights reserved.

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