Some investors who lost money with Bernie Madoff may actually be better off than if they had invested in, say, Citigroup. If you bought Citigroup a year ago and hung onto the stock, you’re down 87%. The IRS will allow you to write that down at a rate of $3000 a year, which means a sizable investment loss could take decades–or centuries–of deductions. But the Madoff losses aren’t ordinary investment losses–they’re theft losses, and you can deduct the full amount right now.
Edward Jay Epstein points out that this could be a considerable boon to investors.
If an investor loses money in legitimate investments, according to the tax code, it is considered an investment capital losses, and the maximum amount he can deduct from his other income is a piddling $3,000 annually. So if he loses a million dollars, it will take him 334 years to deduct it. If, on the other hand, an investor put his million with Bernie Madoff, he could deduct the entire million immediately from other taxes because, as far as the IRS is concerned, it proceeded from a theft, not an investment loss. If the investor was in a 60% bracket- as presumably almost all of Madoff’s Palm Beach investors were- and he had other taxable income—past or present, his bottom line loss from the million would be only $400,000. Consider, for example, if a prudent investor had bought $1 million worth of shares a year ago in such blue chip stocks as Citibank, Bank of America, AIG, Ambac, General Motors or Barclays Bank, which fell between 81 and 90 per cent in value (as of January 19th), which, if he sold them, would leave him with an after-tax loss of over $800,000, or, about twice the loss he would have sustained if he had let Bernie madoff swindle him out of the million.
That’s pretty great. Unfortunately, a lot of Madoff investors are not in the income tax bracket Epstein imagines. That’s because they are retirees, living off of investment income taxed as capital gains. Many have very little ordinary income. Some probably have none. Without income, there’s nothing to deduct the losses against. The deduction is worthless.
But it doesn’t have to be. Why not borrow a page from corporate mergers and acquisitions and let retirees market their tax deductions? In corporate America its not at all uncommon for a corporation with lots of losses to be purchased by a profitable company seeking to reduce its tax burden. The acquired company’s tax deductions get acquired when the company is bought out. The merged company then gets to use those deductions to reduce the taxes it pays. (It’s a bit more complicated than that, of course. But that’s the general idea.)
People can’t sell themselves in this way, unless you count getting married. But there’s no reason why we couldn’t tinker with the rules and let Madoff victims with large losses sell those to people who want to reduce their own taxes. This would allow Madoff victims with little income to turn a useless tax deduction into a valuable asset, reducing the pain of Madoff’s losses. So let’s make some lemonade out of the Madoff lemon!