ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – DEDUCTING A CASUALTY LOSS ON A BAD INVESTMENT – THE ETESSAM CASE
By Robert S. Schriebman
The IRS and California allow deductions on your income tax return for certain types of losses. Losses are divided into three prime categories:
- A loss arising from a trade or business
- A loss arising from any transaction entered into for profit, though not connected with a trade or business (usually investments)
- Casualty losses – those losses usually arising from a natural disaster, fire, store, shipwreck, or other casualties.
As a rule of thumb, a casualty loss must arise from an event that is sudden, unusual, or unexpected. The rules regarding casualty losses are found at IRC § 165 (c)(3) and R&TC § 18031, et. seq. A casualty loss is usually deducted from ordinary income, but a loss from an investment may only be deducted from capital gains and other limiting rules. The casualty loss must be greater than $100.
The casualty loss rules are nothing new. They have remained essentially unchanged since the 1954 code. Yet, these old rules continue to be litigated.
Recently, a California Office of Tax Appeals (OTA) decided the case of Etessam and Estate of Dariush Etessam, OTA Case No. 21017118, October 2022). Let’s take a look at it.
The Etessam Case
Etessam wanted to buy a sublease for the Clarion Hotel. He was attracted to the $31,000 per month rental income. In fact, he was so fixated by this cash flow that he failed to take into account prior secured mortgages and senior liens that had a higher claim to this income. In other words, Etessam did not do his due diligence. The hotel leasehold was up for bid. Etessam made an opening bid of $3.6 million. Another person in the audience drove up the bid to $6.3 million. Etessam was the final successful bidder. At the auction it was understood that no representations were made as a matter of law as to the condition or value of the property sold. This meant that Etessam had constructive notice of senior liens recorded against the property that he purchased. After winning the bid, he discovered to his horror that there were superior liens and mortgages that had priority to the $31,000 monthly income. Etessam was left with no cash flow. He filed a lawsuit in Superior Court against the person on the other side of the bidding war who also happened to be a holder of one of the mortgages. The lawsuit alleged fraud and other claims. The Superior Court’s Final Statement of Decision found that there was no fraud and, also found that Etessam caused his own losses by investing in a leasehold that was subject to two senior deeds of trust that were of record and in default. Further, the Court found that Etessam was not entitled to recover any rents due to the defaulted senior liens. In other words, the Superior Court faulted Etessam for not doing his due diligence.
Etessam filed an income tax return taking a $6.3 million casualty loss due to fraud and seeking substantial refunds. The FTB denied the refund claim. What did the OTA decide?
The OTA Decision
The OTA ruled against Etessam primarily relying upon the Superior Court’s Final Statement and Decision showing no fraud on the part of the senior lien holders. Etessam’s loss was due to his own absence of due diligence and was not a loss arising from a sudden, unusual, and unexpected event that was not foreseeable.
The casualty loss must be the result of a catastrophic event that is sudden, unusual, and unexpected. The loss experienced in the Etessam case was not such a loss. If a strong wind knocks down your fence, this may be a casualty loss. If your bicycle is stolen while you were sipping coffee at Starbucks, that’s a casualty loss. If a thief rips off your catalytic converter, that’s a casualty loss. On the other hand, if your swimming pool develops a slow leak that eventually requires that the pool be rebuilt, that may not be a casualty loss. The casualty loss may not be allowed if your loss is covered by insurance. Only the fair market value of what is not covered by insurance may qualify as a casualty loss.
Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 50 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD, and he is not employed by the EDD or any other agency of the State of California.
Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
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