During the late 1990s, with the stock market in full swing, many people invested in "variable annuities. It's easy to see the appeal: Taxes on any gains from these investments were deferred until investors took distributions from them. Variable annuities became a nice way to build funds on a tax-deferred basis while reaping the riches of the big bull market. But two events made variable annuities lose much of their luster.

• First, in early 2000, the market's bubble burst.
  
• Then tax laws changed, reducing rates on long-term gains -- from stocks held in a regular taxable account for more than a year -- from 20% to 15%. No matter how long you hold stocks in a variable annuity, any profits taken from it are treated as ordinary income, which can be taxed at the highest marginal rate. Even with their taxes deferred, variable annuities suddenly seemed a lot less lucrative.

Variable annuities are still a viable investment product for many folks -- but many others have decided to cash them out to save on the eventual taxes. I've been asked many times about potential losses realized from selling annuities: Are they deductible? How much is the deduction? When should it be claimed?

To answer these questions, let's start with an example.

Gracie invested $100,000 in a variable annuity a few years back. The value of the annuity is now $80,000. Gracie is told that if she cashes out the annuity, she'll have to pay a surrender charge of $5,000, leaving her with a total of $75,000. Given all of this, Gracie decides to pull the plug, and the annuity company sends her a check for $75,000 (and very little else).

Gracie lost $25,000 in real dollars. However, she can deduct only $20,000 of that -- the amount she lost from the money she originally invested. The $5,000 surrender charge is absolutely not deductible in any way.

Remember that a deductible loss is realized only if the annuity is completely cashed out or otherwise surrendered. If you get talked into "trading" your current annuity for another one using the provisions found in Code Section 1035, any gain or loss on the prior annuity will simply follow you into the new one, and you'll have neither income nor deductions to report on the exchange.

One silver lining to Gracie's misfortune: She won't have to pay a penalty tax of 10% on any of the $75,000 left in the annuity, even if she is not yet age 59 1/2. The penalty applies only to gains or income when an annuity is cashed out. Since Gracie actually lost money from her initial investment, she's spared the tax hit.

You might think that Gracie's $20,000 is a capital loss, to be reported on Schedule D with other investment losses, but that's not quite the case. The IRS has clearly ruled that losses like these are ordinary losses, not investment losses.

Where you report that ordinary loss will depend on how aggressive you want to be when preparing your tax return. Conservative filers can claim it as a miscellaneous itemized deduction on Schedule A. But that schedule allows you to deduct only the portion of the loss that exceeds 2% of your adjusted gross income (AGI). So if you have high AGI -- let's assume that Gracie's is $150,000, with no other miscellaneous itemized deductions -- your actual deduction will be limited to less than your loss. In this case, Gracie's 2% works out to $3,000. Subtracting that from the $20,000 she lost in the annuity, she can only deduct $17,000. It gets worse: Large miscellaneous itemized deductions can wreck havoc with the Alternative Minimum Tax (AMT). So claiming the loss as a miscellaneous itemized deduction is a tough route no matter what. (And if you don't itemize deductions, you'll be subject to the 2% hit and the standard deduction. Ouch.)

Want to try a more daring approach? Take the loss using Form 4797, and then move that Form 4797 number directly to the front of your tax return (line 14 for 2004) under "other gains or losses." This method lets you deduct the full loss without that 2% bite. Additionally, you'll have no AMT issues, and the loss will help to reduce your AGI, which might help you in many other ways.

It'd be nice if the IRS could give us firm guidelines for claiming losses from variable annuities, but we have nothing so far. You or your professional tax advisor will have to determine how much risk you'd like to assume when preparing your return. I believe that the aggressive approach noted above is not only defensible, but also makes a great amount of sense from a tax law standpoint. Still, the IRS might think otherwise. If you take that route, be ready for a fight, albeit one I believe you can most likely win.

If you'd like to read what little authority there is on this issue, visit the IRS website and check out Revenue Ruling (Rev. Rul.) 61-201 and 72-193. If you've recently sold a variable annuity at a loss, it might make for a real page-turner.

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