People who pay large amounts of taxes might be forgiven for thinking of the federal government as a Ponzi scheme that takes in tax money and produces federal gravy. It is even worse if one loses money to a real life Ponzi schemer. However, on a positive note, one can claim a tax loss when defrauded.

The IRS recognizes the possibility of taxpayers getting defrauded and has theft loss deductions that are available in various forms. The IRS provided safe harbor, beginning in 2007, for Ponzi schemes victims. In Ponzi schemes, differentiating between what is real and what is counterfeit is not very straight forward.  In the IRS tax relief, filing of criminal charges against perpetrators of such schemes was a major component of the relief although the IRS accepted that there would be no criminal charges if the perpetrator was dead. The IRS revenue procedure 2009-20, therefore, outlines safe harbors for victims of Ponzi schemes, to cater for situations where the perpetrator is dead and foreclosed criminal charges.

However, the IRS, in the Revenue Procedure 2011-58, has redefined the “qualified loss” from its initial description in 2007. The new definition allows a theft loss and not a capital loss for scheme investors. The usual limits on investment losses do not apply on a theft loss from a Ponzi scheme. The regulations usually permit only $3,000 per annum beyond capital gains from investments.

The deduction is supposed to be done in the year one discovers the fraud unless one has a claim that stands a good chance of recovery. The determination of the discovery year and application of the rule on “reasonable prospect of recovery” depends on one’s facts.

One’s theft loss can include lost investments, including earnings reported in past years. Ponzi scheme investors can apply for a theft loss deduction for the entire amount invested and even for “income” paid from the scheme promoter and for which tax was paid for before one discovered the fraud.

Due to the fact that most taxpayers file earnings from Ponzi schemes as fictitious income and pay income taxes for them, they have made a suggestion to the IRS to have their prior tax returns filed in such manner reviewed. However, the Internal Revenue Service has failed to share their opinion and as a result, it has not addressed the issue in its guidance for Ponzi Schemes losses, however, individuals who are not sure about their claims can seek proper guidance from professionals.