Thousands of people lost their money when Bernard Madoff made off with it. He did not make off with it in the usual sense - he kept some for himself, and used the rest to attract other people so that he could take their money, take some for himself, and use the rest to attract still more money. For year's people thought Bernard was a saint, until the requests for redemption came and he could not meet them.
Those who thought they were receiving dividends, interest, and trading gains were actually receiving little in the way of dividends and interest, and no trading gains. Apparently Madoff was not buying and selling securities at all.
Victims presumably reported the "phantom income" as interest, dividends, or capital gains. What the victims were receiving was part of the funds of other victims. This is not income for federal or Massachusetts tax purposes.
The losses will be a deductible against ordinary income and capital gain income. The IRS claims that a theft loss is deductible only to the extent that it exceeds 10% of adjusted gross income. I believe that this is not a correct statement of the law, and the Tax Court agreed, in Premji v. Commissioner.
A theft loss is claimed in the year when theft is discovered. If the taxpayer has a reasonable prospect of recovering some amount, that amount is not claimed as a deduction unless and until it also appears lost for good.
Federal tax refund claims may be filed for three years. For most taxpayers 2005, 2006, and 2007 are "open years" and the taxpayers should file protective refund claims for phantom income for those years.
Treatment of phantom income from closed years is not clear. An aggressive approach would be to add the phantom income to the original investment in computing the loss.
If a taxpayer is called on to repay to the Madoff bankruptcy trustee some or all of the phantom income received, this may be deductible for tax purposes.
I hope that nobody reading this was a victim of Mr. Madoff. If you were a victim, we will be glad to help you determine the proper tax treatment of your losses.
