Bloomberg: Madoff’s Victims May Recover Losses Through Tax Code, by Ryan J. Donmoyer:

Individual investors who lost money in Bernard Madoff’s alleged $50 billion fraud may be able to recover some of their money by seeking U.S. tax refunds. “The Madoff debacle will result in what amounts to another federal government bailout,” said Warren Kessler, an attorney at the Los Angeles law firm Kessler & Kessler. “It is likely that the Treasury will wind up refunding taxes,” at least on the loss of money individuals invested with Madoff, he said.

Capital-gains taxes paid by investors may be refundable for 2005 through 2007, lawyers said. In addition, they said investors probably can convince the IRS they are victims of theft, which would let them deduct losses from their income taxes dating back to 2005. Any unused theft losses could be used to reduce tax liabilities for the next 20 years. …

Many of Madoff’s investors were charities and pension funds that were tax-exempt and wouldn’t be owed a refund. The extent of refunds to investors who paid taxes will depend on how much theft loss can be deducted by individuals and how much investment income was fraudulently reported to the IRS.

John Barrie, a tax partner at the New York law firm Bryan Cave LLP, said investors will want to claim a theft loss rather than an investment loss. A theft loss can be used to reduce ordinary income, while an investment loss can only offset capital gains, which most people don’t have this year, he said.

See also:

• Dealscape:  A Bailout for Madoff's Victims?
• Market Mover, Madoff: The Tax Implications, by Felix Salmon
• New York Times:  Investors With Madoff May Get Tax Relief, by Lynnley Browning
• NPR:  The Madoff Tax Break
• Roth & Co.:  Theft Loss for Madoff Victims?, by Joe Kristan
• The Tax Lawyer's Blog:  Theft Losses for Victims of Madoff Fraud?  by  Peter Pappas 
• Wall Street Journal:  Investors May Have to Surrender Gains, by Jane J. Kim, Jenny Strasburg & Aaron Lucchetti