During the late 1990s, with the stock market in full swing, many people invested in variable annuities. This type of investment was preferred since the taxes on any gains were deferred until distributions were taken from the annuity. So it was a nice way to build funds on a tax-deferred basis while at the same time taking advantage of the big bull market.

But two things happened that made variable annuities less attractive for many people. The first was the scalding of the market in early 2000. The second was the tax change that dropped the tax rates on long-term gains from 20% down to 15%. Remember that profits taken from a variable annuity are treated as ordinary income, which can be taxed at the highest marginal tax rate. And that's true no matter how long you held the stocks in the annuity to create that profit. On the other hand, stocks held for more than a year in a regular taxable account receive a favorable 15% maximum tax rate. So the difference in taking profits out of a variable annuity (even with the taxes deferred), and simply paying taxes on long-term gains as they are realized can be substantial.

That's not to say that variable annuities aren't still a viable investment product for many folks. It's just to point out the fact that many of you have simply decided to "cash out" your annuity. And I've been asked many times about the losses that might have been realized when the annuity was sold. Are those losses deductible? And if so, how much is the deduction? And where should the deduction be claimed?

These are all great questions, and I'll answer them in a few more paragraphs. But let's get the ball rolling with an example.

Gracie invested $100,000 in a variable 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. Given all of this, Gracie decides to pull the plug on the annuity. So the annuity company sends her a check (and likely very little else by way of information) for $75,000, representing the value of the annuity of $80,000 less the surrender charge of $5,000. Gracie has a deductible loss of $20,000.

Gracie's cost basis in the contract was $100,000, representing the money she originally invested. She actually sold the annuity for $80,000. Subtract the two amounts, and you arrive at a loss of $20,000. What about the $5,000 surrender charge? Completely not deductible in any way, shape, or form. So while Gracie lost $25,000 in real dollars after all is said and done, her deductible loss is only $20,000. And remember that this 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 annuity, and you'll have no income nor deductions to report on the exchange.

Another thing to note about Gracie's misfortune is that she'll not have to pay a penalty tax of 10% on any of the proceeds from the annuity, even if she is not yet age 59 and a half. Remember that this 10% penalty is only applicable to gains or income when the annuity is cashed out. In Gracie's case, she realized a loss after all was said and done. So the 10% penalty doesn't come into play at all.

We've now determined that Gracie suffered a $20,000 loss. Where should it be reported? You would immediately think that you have a capital loss to be reported on Schedule D. But that's entirely not the case. IRS rulings on this subject are clear that the loss is not an "investment loss," but rather an ordinary loss. So it can't be reported on Schedule D.

So where should the ordinary loss be reported? That depends on how aggressive you want to be when the tax return is prepared. The conservative approach would be to claim it as a miscellaneous itemized deduction on Schedule A. But taking the loss as such requires that you can report only the loss that exceeds 2% of your adjusted gross income (AGI). So if you have high AGI (let's assume that Gracie's AGI is $150,000 and that she has no other miscellaneous itemized deductions), your actual deduction will be limited to less than your loss (Gracie's deduction would be only $17,000). Worse yet, what if you don't itemize your deductions? In that case, if your loss were large enough, you would be limited by the 2% rule for miscellaneous itemized deductions and would also be limited by the standard deduction, which you receive simply for being you. And, just when you thought it couldn't get any worse, it does. Large miscellaneous itemized deductions can wreck havoc with the Alternative Minimum Tax. So claiming the loss as a miscellaneous itemized deduction is a tough way to go no matter how you slice it.

But the more aggressive approach would be to take the loss using Form 4797 and then taking the loss from Form 4797 directly to the front of your tax return (line 14 for 2003) as an "other gains or losses." Using this method, you can deduct the full loss without being subject to the 2% floor mentioned above. 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 as to claiming the loss, but we have nothing so far. So you (or your professional tax advisor) will have to determine how much risk you'd like to assume when preparing the return. I personally believe that the aggressive approach noted above is not only defendable but also makes a great amount of sense from a tax law standpoint. But it is a position that might be challenged by the IRS, so you might want to be ready for a fight -- but a very winnable fight (at least in my opinion). If you'd like to read what little authority there is on this point, head on over to 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, you might find the reading fascinating.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.