This is a gray area in the tax law that you may use to your advantage. IRS Publication 575 says that you must report the loss as a Schedule A miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income limit. The IRS is on thin ice here, I believe, because the U.S. 5th Circuit Court of Appeals has held in McIngvale v. Commissioner that a loss on a private annuity is a capital loss, hence deductible on Schedule D.

Because the IRS and the Court are split on the treatment of a loss on a variable annuity, I recommend deducting the loss either on Schedule A as a miscellaneous itemized deduction or on Schedule D as a capital loss depending on where you’ll receive the greater tax benefit.

As published in Austin Monthly, April 2003 (amended February 2005)