The IRS allows special relief for victims of Ponzi schemes. Because Ponzi-type schemes can continue for years, many investors wind up faced not only with the loss of their original investments, but also with having paid taxes on “phantom income,” based on fraudulent statements or estimates. If you have losses from a virtual currency exchange failure, or lost your investment in a bogus virtual currency, you may qualify for favorable tax treatment on the loss.
How are Ponzi losses treated?
If the loss was considered a capital loss, which is often the case when a taxpayer loses money on an investment in stocks or other forms of non-business property, 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 many investors in large frauds. As a result, the IRS announced in 2009 that investors can take an ordinary loss deduction for Ponzi-type losses that 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.
When is the deduction taken?
US taxpayers can deduct the loss in the year they discover it. 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 ascertained. And a taxpayer is required to include in income any amount recovered greater than the amount anticipated at the time of taking the deduction.
How much is the deduction?
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investment any additional investments and any amounts the taxpayer reported as income and reinvested, minus any amounts withdrawn over the years and any reimbursements or likely recovery.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 also an alternative way to calculate the loss under an elective provision, which is described below.
Net operating losses
Taxpayers with Ponzi losses may have loss deductions in excess of their income for the year of the deduction. Under the general rules for net operating losses (NOLs), the losses can be carried back two years and forward 20 years. For casualty or theft losses, the carryback is increased to three years. The interaction of the NOL rules with the rules for other deductions and credits is complex; if you had a potential NOL, you needed tax advice before choosing a carryback period.
Safe-harbor relief for Ponzi losses
Some investors will qualify for elective relief under Revenue Procedure 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. But 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 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). The safe harbor can be elected only by investors who invested directly with a similar fraudulent scheme.
To qualify for relief under Revenue Procedure 2009-20, investors must file Form 4684, Casualties and Thefts, marked “Revenue Procedure 2009-20,” with the tax return for the year in which the theft was discovered. Appendix A of Revenue Procedure 2009-20 contains a worksheet for calculating the amount of the theft loss and a statement that must be signed by the investor and submitted with Form 4684. This can be done on extension.
State tax treatment
Each state may treat these losses differently. New York, for example, has announced that it will recognize the safe harbor under Revenue Procedure 2009-20 for purposes of determining the amount of New York state itemized deductions for the theft loss. However, itemized deductions in New York are reduced for taxpayers with income in excess of certain thresholds (that is also the case for federal income tax purposes, but the IRS has explicitly excepted these losses from those reductions). Also, the NOL provisions permitted for federal purposes aren’t permitted for New York because the state allows NOL deductions only for losses attributable to a business, trade, profession, or occupation carried on in New York. The losses from a Ponzi-like fraudulent investment arrangement generally won’t qualify.
If you think you may have suffered a loss due to a Ponzi or other fraudulent scheme, contact us to discuss how we can help you take full advantage of IRS rules.