Madoff victims could turn to tax code for relief

BOSTON (Reuters) - A law designed to protect uninsured Americans who lose a television or other valuables to thieves could provide a glimmer of relief for thousands of investors burned by possibly one of Wall Street's biggest frauds.

Investors swindled by former Nasdaq Chairman Bernard Madoff's alleged $50 billion fraud are exploring ways to recoup at least some of their money through so-called "theft loss" deductions or other tax refunds.

Those tax-code features could help shell-shocked investors recover potentially hundreds of millions or even billions of dollars, lawyers and tax advisors say.

"Just from watching the TV, I can see this is a theft," said Robert Willens, a New York tax adviser. "And theft losses are treated much more favorably than most other losses are treated for tax purposes."

Theft-loss provisions were intended to help uninsured people whose property was stolen, damaged or destroyed in an accident or by an act of nature -- from storms to earthquakes.

But they also apply to fraud-related investments. Taxpayers can deduct theft losses if they exceed 10 percent of their adjusted gross income in the year the fraud was discovered, which is 2008. Given the massive scale of fraud, losses for many of Madoff's investors could top the 10 percent threshold.

Those deductions can be made on income taxes dating to 2005. And any unused losses can be used to reduce tax liabilities for the next 20 years, said Warren Kessler, an attorney at the Los Angeles law firm Kessler & Kessler.

"There is no question that it applies in this context. It's pretty clear that this is a theft loss," he said.

There are important caveats: In order to claim the deduction, it has to be a reasonable chance an investor will not recoup their losses. That means those who pursue class- action lawsuits may be ineligible.

It could also make deductions off limits to those who lost money through so-called feeder funds, or hedge funds set up by outside investment advisory firms that marketed Madoff's investments to high net-worth individuals and pension funds.

Exceptions also include charities and pension funds that were tax-exempt. And investors in Madoff's business who are compensated by the government-sponsored Securities Investor Protection Corp may have trouble getting deductions.

"LIKE A MINI-BAILOUT"

But for those who are eligible, the money could be big.

An individual investor who lost $100 million, for example, may be able to recoup $35 million through a deduction against ordinary income, usually taxed for wealthy investors at the top rate of 35 percent, tax lawyers say.

"If the size of Madoff's fraud is $50 billion, let's say individuals are half of that, or $25 billion. For federal tax purposes they will get back 35 percent, or nearly $9 billion. That's like a mini-bailout," Kessler said.

John Barrie, a tax partner at the New York law firm Bryan Cave LLP, sees other tax implications because of the nature of Ponzi schemes, which pay off old investors with money from new ones and rely on a constant stream of new investment.

Madoff, 70, is accused of defrauding banks, charities and rich individuals through a long-running Ponzi scheme executed at Bernard L. Madoff Investment Securities LLC, which he launched in 1960.

Many of Madoff's investors should be able to seek refunds on capital-gains taxes paid for 2005 through 2007.

"They would have paid taxes on things that were never there. They should file amended returns to restate their returns going back three years to eliminate that income," Barrie said, noting the refund is limited to three years.

"Those that have been there a long time are stuck with what they have on their returns."

Mark Robyn, an analyst at the Tax Foundation, a nonprofit research group in Washington, expected many of those burned by Madoff to seek relief through the U.S. tax code.

"It seems like something that most investors will be able to take advantage of," he said.

It is unclear, however, whether the Internal Revenue Service will allow Madoff's investors to use theft-loss rules. The agency has kept quiet on the issue.

"We are aware of the situation, but beyond that we have no comment," said IRS spokesman Bruce Friedland.

Willens said many investors may be better served by pursuing tax refunds instead of litigation, which could drag on for years.

"My advice is to not file a claim for reimbursement and instead take the loss right away and you'll recoup 35 percent of it through tax refunds," he added.

(Editing by Andre Grenon)