Former J. David Investors Now Face Taxing Problem

Former J. David & Co. investors are faced with some rather taxing questions, none of which is easily answered and most of which will involve a curious examination by the Internal Revenue Service.

The bottom line is that investors in the failed La Jolla investment firm cannot write off the investments they may have lost until the complicated bankruptcy proceedings are complete and distributions are made--and that could take years.

Because no legal determination of fraud has been made against either J. David & Co. or its founder, J. David (Jerry) Dominelli, writing off investments as an investment or fraud loss would be premature, according to bankruptcy attorneys and San Diego accountants.

However, investors who were burned in the J. David fiasco may be able to get some tax relief.

The rub is that they must have declared on their past income tax returns the interest they received from J. David. If they did not, they must wait until the bankruptcy case is resolved before writing off any J. David losses.

For those who did declare their J. David interest--even if they never received the actual money --taxes paid on that income could be recaptured by amending prior years’ tax returns.

As an example, assume that an investor had $100,000 in the La Jolla company. Also assume that the investor received statements reporting interest income of $50,000, which was declared to tax authorities. Then, assume that the investor withdrew $40,000 from the account.

The investor could amend prior tax returns to recoup the tax paid on the non-existent interest, according to tax lawyers.

That would leave the investor with only $60,000 in lost J. David capital because $40,000 had been withdrawn from the original $100,000 investment.

If the investor later writes off the $60,000 as a fraud or theft loss, the entire amount could be deducted during one tax year.

If, however, the investment is written off as a capital loss--the opposite of a capital gain--then only $3,000 per year could be deducted. The capital loss treatment is different because capital gains are taxed at a much lower rate than ordinary income. As a result, capital losses offset income at a lower rate than ordinary losses do.

If that sounds confusing, tax attorneys say, that’s because it is.

Even the Internal Revenue Service isn’t sure what to do.

“It’s still not known whether this should be treated as a fraud or investment loss,” according to IRS spokeswoman Judith Golden. “That may take audits and rulings from our national office.”

And that could indeed take some time.