This year has seen the occurrence of dramatic casualty events across the country, from tornados in the Midwest, to wildfires in Colorado, Oklahoma, and Texas, to Hurricane Isaac in the Gulf Coast. These and other casualty events have resulted in billions of dollars in property damage. Hopefully, individuals and businesses impacted by these events carried sufficient insurance, including special flood insurance, to be compensated for their property losses.
However, when casualty losses exceed insurance recoveries, tax deductions afford some financial relief to affected taxpayers. Refunds may even be available to provide cash that is helpful for rebuilding after severe losses. What’s more, in some cases, taxpayers can also have more time to complete their tax obligations.
Tax-deductible losses
1. For tax purposes, a casualty loss is damage to property resulting from a casualty event such as a fire, storm, or other sudden or unusual event (Code Sec. 165(c)(3)). It is up to the taxpayer to prove that the damage resulted from a casualty, which is not difficult to do when an event affects a large area.
2. It becomes more challenging when the event is limited to a single taxpayer, such as fire to a taxpayer’s residence. In this case, it is advisable for the taxpayer to keep records that will prove a casualty was responsible for property damage, such as “after” pictures, insurance claims, police reports, and news accounts of the event.
3. For nonbusiness (personal) property, the loss is lesser of the adjusted basis of the property (typically cost) or the difference between the property’s value before and after the disaster. The loss is reduced by any insurance and other reimbursements and by $100. Then total losses for the year are deductible as an itemized deduction to the extent they exceed 10% of adjusted gross income (AGI).
Non-business Casualty Loss Worksheet:
Adjusted Basis ________ (a)
Value Before Loss ________ (b)
Value After Loss ________ (c)
Difference ________ (d)
Lesser of (a) or (d) ________(e)
Less: Insurance proceeds (________)
and other reimbursements (________)
Less ( $100 )
Net ________ (f)
10% of AGI ________ (g)
Any excess of (f) over (g) ________
is deductable as an itemized deduction.
4. Losses to business or investment property are fully deductible; they are not reduced by $100 and are not subject to the 10%-of-AGI limit. For property that is totally destroyed and not covered by insurance, the loss is the property’s adjusted basis. Where property has been expensed or fully depreciated, this means a zero basis so no tax loss can be claimed.
Disaster losses
5. If the loss occurs within an area declared eligible for federal disaster relief from the Federal Emergency Management Agency (FEMA), then there is a helpful tax option to consider. The loss can be claimed on a tax return for the year of the casualty event or for the prior year (Code Sec. 165(h)). Claiming the loss for the prior year entitles a taxpayer to receive a tax refund, which can be used to help rebuild after the disaster. The IRS lists areas qualifying for this disaster relief at www.irs.gov/uac/Tax-Relief-in-Disaster-Situations.
To claim the loss on a prior year return, take the loss into account if the return has not yet been filed. If the return has already been filed, then an amended return is required.
Problem areas in casualty losses
6. One of the more difficult matters in claiming a casualty loss is proving the amount of the loss. If there is a complete destruction of the property, the loss is limited to the lower of the fair market value of the property immediately before the destruction or its adjusted basis. If there is merely damage to property, the loss is limited to the lesser of the fair market value of the property immediately before the casualty, reduced by its fair market value immediately after the casualty, or the property’s adjusted basis.
Fair market value usually is ascertained by an appraisal made by a “competent” appraiser (Reg. §1.165-7(a)(2)(i)). The appraisal must take into account the effects of any general market decline affecting undamaged as well as damaged property, which may occur simultaneously with the casualty event.
7. The IRS and courts are rather particular about whether an appraisal is acceptable for proving fair market value. In one recent case, the Appellate Court for the Ninth Circuit affirmed a Tax Court decision that rejected the taxpayers’ claimed casualty loss deduction (Sykes, CA-9, 2012-2 USTC ¶50,485, aff’g TC Memo 2010-84). The taxpayers in this case sustained water damage to their home from a busted water pipe and received an insurance reimbursement of about $4,300 based on the cost of repairs to the damaged property in the home. They hired someone as a qualified appraiser. The taxpayers adjusted the numbers presented by this appraiser and then claimed that the casualty caused a reduction in the value of their home of more than $45,000 and they deducted another $40,000 or so in losses.
8. The taxpayers’ adjustments to a qualified appraiser’s report (believing values to be overstated in the report) do not amount to a qualified appraisal and cannot be used as a basis for a casualty loss deduction. The taxpayers did not call any witnesses nor testify themselves to substantiate the valuation of their claimed loss; they did not submit any supplemental materials to establish that their estimation of the loss should be used for tax purposes.
9. Instead of obtaining an appraisal, the cost of repairs to the damaged property is acceptable evidence of the loss in value if (Reg. §1.165-7(a)(2)(ii)):
1. The repairs are necessary to restore the property to its pre-casualty condition,
2. The amount spent for repairs is not excessive,
3. The repairs relate only to the damage suffered in the casualty, and
4. The value of the property after the repairs does not exceed its value immediately before the casualty.
Only the amount of the loss is deductible. No deduction can be claimed for a sentimental or ascetic loss.
10. Another issue is the tax treatment of reimbursements from state funds as compensation for property damage. The IRS says (www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/FAQs-for-Disaster-Victims---Taxable-State-Recovery-Payments) that if a taxpayer claimed a casualty loss deduction and, in a later year, receives reimbursement for the loss, the taxpayer reports the amount of the reimbursement in gross income in the tax year it is received to the extent the casualty loss deduction reduced the taxpayer’s income tax in the year in which the taxpayer reported the casualty loss deduction; the taxable amount is determined under the tax benefit rule (Code Sec. 111).
11. If the reimbursement exceeds the amount of the casualty loss deduction, the taxpayer reduces basis in the property by the amount of the excess; the taxpayer includes such excess in income as gain to the extent it exceeds the remaining basis in the property, unless such gain is excludable from income or its recognition can be deferred as gain from an involuntary conversion under Code Sec. 1033.
12. Yet another concern for victims of casualty events is the loss of their tax records. Reconstruction of tax records in this situation is permissible, and in fact necessary, to help taxpayers prove their casualty loss deductions. It may be advisable to store tax and financial records so they will not be impacted by a disaster (e.g., using off-site backup for computer files).
Other tax relief for disaster victims
13. From time to time, disasters are so severe that the IRS gives affected individuals and businesses more time to file returns, pay taxes, and do other time-sensitive tax chores. Recently, the IRS granted relief to certain victims affected by Hurricane Isaac (IR-2012-70, 9/5/12). Affected individuals and businesses have until January 11, 2013, to file 2011 returns that were on extension, which includes corporations and other businesses that would normally have filed by September 17, 2012, and individuals who would have filed by October 15, 2012.
14. The IRS cannot extend the time for depositing taxes or filing employment and excise tax returns. However, it can provide relief, as it has done for affective individuals and businesses. The IRS will also abate any interest, late-payment or late-filing penalty that would otherwise apply to these returns. In addition, for businesses the IRS will waive failure-to-deposit penalties for federal employment and excise tax deposits normally due on or after August 26, 2012, and before September 10, 2012, if the deposits are made by September 10, 2012.
As of now, this relief applies only to victims within Louisiana (Ascension, Jefferson, Lafourche, Livingston, Orleans, Plaquemines, St. Bernard, St. Charles, St. John the Baptist and St. Tammany parishes) and Mississippi (Hancock, Harrison, Jackson and Pearl counties), but the IRS is expected to extend this relief soon to other storm-related victims.
Conclusion
15. The IRS has a new landing page on disaster assistance and emergency relief for individuals and businesses at www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Disaster-Assistance-and-Emergency-Relief-for-Individuals-and-Businesses-1.
Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.
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