02/22/2009 05:12 am ET | Updated May 25, 2011

The Silver Linings: the Madoff Tax Credit

Don't cry (yet) for investors in Bernie Madoff's grand Ponzi scheme -- or at least for those of them who pay taxes. As bad as they may have done in their calculated effort to beat the system by betting with one of the stock exchange's major market makers, thanks to an odd feature of the US tax code they will probably wind up losing less money than ordinary investors had by buying shares in some of the largest companies on the New York Stock Exchange.

If an investor has a net loss in legitimate investments, according to the tax code, it is considered an investment capital loss, 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 that 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 50% 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 $500,000. 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 percent in value (as of January 19th), which, if he sold them, would leave him with an after-tax loss of over $800,000, or, much more than the loss he would have sustained if he had let Bernie madoff swindle him out of the million.

Even better, to the extent that Madoff's investors paid taxes on false capital gains booked in their accounts during the prior five years, they are owed tax refunds -- with interest. It also turns out that since virtually all hedge fund partners are limited partners, the entity's theft loss flows through to them, and they therefore can also take advantage of the Madoff tax credit for their personal tax returns. So as painful as it is to lose money in a Ponzi scheme is, it is more painful to lose it in a legitimate investments where the loss it is not tax deductible for centuries.

The US government stands to lose a vast amount of tax revenue through the Madoff tax credit -- as investors may deduct billions of dollars worth of their loss against other income. But there is also a silver lining for the government. According to my knowledgeable source, Treasury department investigators are now discovering that a great many of Madoff's investors funneled their money through off shore accounts without reporting them. The IRS thus will be able to level immense penalties on these tax-dodgers for hiding off shore income-even if it was fictive income. But are tax-dodgers really deserving of pity?

The real victims are the tax-exempt players, especially the legitimate philanthropies, that sunk their funds in Madoff's Ponzi scheme. Alas, they cannot recoup any of their losses. The tragic flaw here was trust. Samuel Johnson adumbrated that danger more than two centuries ago when he wrote about the bankruptcy of merchants, that assumed the splendour of wealth only to obtain the privilege of trading with the stock of other men, and of contracting debts which nothing but lucky casualties could enable them to pay; till after having supported their appearance a while by tumultuary magnificence of boundless traffic, they sink at once, and drag down into poverty those whom their equipages had induced to trust them."