In 2009 the IRS has announced relief for victims of Ponzi schemes and similar fraudulent investment schemes. Since fraudulent investment schemes continue for years, many investors are faced not only with the loss of their original investments, but also with having paid taxes on “fictitious income,” based on fraudulent statements sent to investors over a number of years.

The first issue the IRS answers is exactly how the loss from the investment will be treated for tax purposes. If the loss was considered a capital loss, which is often the case when a taxpayer loses money on an investment in stocks or securities, individual taxpayers would be limited to offsetting the loss against their capital gains, plus an additional $3,000 allowed as a deduction against ordinary income. Although the excess loss can be carried forward indefinitely, it would do little for losses of the magnitude incurred by the typical investor in a fraudulent scheme. So it was good news for investors when IRS announced that investors can take an ordinary loss deduction and the deduction isn’t subject to the 2% of adjusted gross income (AGI) limit on miscellaneous itemized deductions, the income-based limitation on itemized deductions, or the 10% of AGI limitation on the deduction for casualty losses.

Taxpayers can deduct the loss in the year the theft was discovered. This deduction can be taken if the loss isn’t covered by a claim for reimbursement or other recovery that has a reasonable chance of occurring. If there is a reasonable chance of recovery, the taxpayer must either reduce the deduction by that amount or, alternatively, make a special election under a 2009 Revenue Procedure, which is discussed farther below. If, after reducing the deduction, the taxpayer actually recovers less than the reduction in a later year, he or she can take an additional deduction in the year the recovery amount is determined. A taxpayer is required to include in income any amount recovered greater than the amount anticipated at the time of taking the deduction.

According to IRS, the amount of the theft loss is determined by adding to the amount of the initial investment any additional investments and any amounts the taxpayer reported as income and reinvested, minus any amounts withdrawn over the years and any reimbursements or likely recovery.  There is an alternative way to calculate the loss under an elective provision described below.

Some investors will qualify for elective relief under Rev Proc 2009-20, 2009-14 IRB 735. The amount of the investment that qualifies for relief under the Revenue Procedure is the same as it is under the rules described above. However, the amount to be deducted is 95% of the qualified investment if the investor doesn’t pursue any potential third party recovery or 75% of the qualified investment if the investor is pursuing or intends to pursue a third party recovery. These amounts must be reduced by any actual recovery or potential SIPC recovery. The biggest advantage of this method is that the deduction isn’t further reduced by a potential direct or third party recovery (although further deductions or income from losses or recoveries occurring in later years are covered by the rules above).