You may be misreading or not understanding the Tax Benefit Rule. Until you recover the amount that reduced your income, the 25% may not come into play or reduce the current income. The proration in the examples is two different types of state tax which are used to determine the amount that actually reduced income and income tax. Ultimately, it is determined based on how much your tax was reduced by the deduction. Worksheet 2 will help you determine the amount you must recover.
Tax benefit rule. IRS Publication 525
You must include a recovery in your income in the year you receive it up to the amount by which the deduction or credit you took for the recovered amount reduced your tax in the earlier year. For this purpose, any increase to an amount carried over to the current year that resulted from the deduction or credit is considered to have reduced your tax in the earlier year.
Since the 75% used for your Ponzi Scheme loss was used 100% to reduce income, until that is recovered through your settlements received, I believe all settlement proceeds are taxable income. Once that is recovered the remainder will not be taxable. Again, Worksheet 2 in the publication will help you figure out the amount you must include in your income.
With your TurboTax account open follow the steps below.
- Scroll to Less Common Income > Select Reimbursed deductions from a prior year > Start or Revisit
- Continue to follow the screens and enter your description and amount
Keep the worksheet in your files for your records.
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