In 2001, Rocky and Bullwinkle (R&B) (MFJ) invested the sum of $250,000 with Boris Badenov, who held himself out to the public as an investment and securities broker. R&B gave Badenov a power of attorney to use the $250,000 sum to buy and sell securities on their behalf. Any income or gains on this initial investment were to be reinvested. In 2002, R&B contributed an additional $50,000, in 2003 an additional $40,000 and in 2004 they contributed an additional $10,000. Badenov periodically issued account statements to R&B that reported the securities purchases, sales, and re-investments that Badenov purportedly made in their investment account. He also issued tax forms and statements to R&B and to the IRS that reflected purported gains and losses on their investment account. Badenov reported to R&B and the IRS that income in 2001 was $25,000, $35,000 in 2002, $65,000 in 2003, in $75,000 in 2004 and $80,000 for each of the years 2005 - 2007. R&B included all of these amounts in their federal gross income on their annual income tax returns. R&B took distributions of $25,000 for each of the years 2003 through 2006 in order to pay for their daughter's college education. No other distributions were made from the account.

In 2008 it was discovered that Badenov's purported investment advisory and brokerage activity was in fact a fraudulent Ponzi scheme, and that his reported investment activities and the resulting income amounts for his investors were partially or wholly fictitious. When Badenov's fraud was discovered in 2008, he had only a small fraction of the funds that he reported on his investors' account balances. As a result, investors would never receive the amount in their account balance, and would receive no reimbursement or other recovery for the loss these funds. Badenov's actions constituted criminal fraud or embezzlement under the laws of the state. R&B had no knowledge that Badenov's activities were a fraudulent scheme. Tax years 2001 through 2004 are closed for R&B (the statute of limitations being three years for their federal income tax returns), but years 2005 through 2007 were still open.

1. What is the character of Rocky's and Bullwinkle's loss? Under what IRC Code Section?

2. What amount is deductible to R&B?

3. What year(s) may R&B take such deductions?