The Internal Revenue Service issued guidance this week on losses sustained by investors involved in Ponzi schemes like the ones allegedly run by Bernie Madoff and Allen Stanford. In prior years, investors would have been reporting earnings and gains on their investments in these schemes. Now it's known that those profits never existed, and the IRS is saying that taxpayers can take a theft loss deduction.

This deduction is to be taken in the year a fraud is discovered, and is not subject to the same limits that would apply to a normal capital loss. This deduction should only be taken if the investor doesn't have a reasonable chance of recovering his losses.

Tax professionals were speculating whether the IRS would allow Madoff and Stanford investors to go back and amend prior years' tax returns to remove the phantom profits that were reported. The IRS has not addressed this issue publicly, which indicates that this would not be the proper treatment. Instead investors should follow the guidance issued this week that will allow them to take the theft loss deduction.

This seems fair, as investors shouldn't be on the hook for taxes on gains and profits that never actually occurred and that they don't have any chance of actually receiving. This isn't much comfort to those who lost their savings in these schemes, but at least it is clear that the IRS won't heap additional punishment on the victims.

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