Deducting Fraudulent Investment Scheme Losses In spite of diligent efforts by regulatory organizations to prevent fraudulent investment schemes, unscrupulous individuals and firms continue to find ways to manipulate the system and defraud unwary investors. Recent high profile multibillion-dollar investment schemes (e.g., Ponzi-type schemes) have cost numerous investors their life savings. In a Ponzi-type scheme, for example, investment managers purportedly invest cash on behalf of each investor in an account with the investor’s name. The investment manager then reports fictitious investment transactions and earnings to the unsuspecting investor. The investment manager uses some funds from new investors to meet principal and earnings withdrawal requests from prior investors. However, a large percentage of the investor’s funds are generally stolen by the investment manager for personal use.   Most of the funds invested in these schemes will never be recovered, but recent tax guidance provides a theft loss deduction for (a) the initial and subsequent investments, less withdrawals and (b) any previously reported income that was never actually received. Hopefully, this taxpayer-friendly provision will provide some monetary relief to those who were victimized. The theft loss deduction is available for the taxable year in which the loss is discovered. However, if there is a possibility a portion of the loss will be recovered, that portion is not considered a theft loss until a final determination is made. Example: Fraudulent investment scheme loss. John invested $200,000 with High Yield Investment Advisors (High Yield) eight years ago. He was so satisfied with the average annual return that he invested an additional $100,000 with High Yield five years ago. John also reinvested his earnings of $162,000 (over seven years) and included the appropriate amount in his taxable income each year. In year seven, he withdrew $50,000 to purchase a new car. In year eight (2009), John was notified that he had been the victim of a Ponzi-type scheme. John was informed that most of his investment and reinvested earnings will never be recovered. However, the liquidation of High Yield’s remaining assets should eventually lead to an approximate $35,000 recovery for John. As a result of the theft by High Yield, John can claim a theft loss of $377,000. His theft loss is comprised of his initial and subsequent investments totaling $300,000 ($200,000 + $100,000); plus the $162,000 reinvested earnings; less his $50,000 withdrawal and $35,000 potential recovery. So, John will be able to deduct $377,000 as a theft loss on his 2009 federal tax return. Whether and when an investor meets the requirements for claiming a theft loss resulting from a fraudulent investment scheme are highly factual determinations. In view of the number of investment arrangements recently discovered to be fraudulent and the extent of the potential losses, an optional safe harbor is available whereby an investor (subject to qualifying characteristics) may treat a loss as a theft loss deduction when certain conditions are met. The safe harbor allows up to 95% of qualified losses, calculated through detailed definitions and formulas, to be deducted as a theft loss. This treatment provides qualified investors with a uniform manner for determining their theft losses and avoids the difficult task of proving how much income reported in prior years was fictitious earnings or simply a return of capital. If you have been victimized in a fraudulent investment scheme, please contact us to determine the best course of action.