The flooding in parts of Louisiana on August 11, 2016, and in Florida on September 2, 2016, was devastating; both lives and property were lost. Property losses from this and other casualty events may be covered by insurance. However, insurance may not adequately compensate individuals and businesses for property damage and destruction. Tax breaks may provide some economic help.
Determining a Casualty Event
A nonbusiness casualty event for individuals seeking to deduct uninsured losses arises from a fire, storm, shipwreck or other casualty. Case law has helped define “other casualty”: as a sudden, unexpected, or unusual event. Examples of casualties include:
• Government-ordered demolition or relocation of a home that is unsafe to use because of a disaster.
• Mine cave-ins.
• Sonic booms.
• Storms, including hurricanes and tornadoes.
• Terrorist attacks.
• Volcanic eruptions.
However, progressive deterioration is not a casualty event for tax purposes. For example, the collapse of a retaining wall that had been deteriorating for an estimated 25 years was not a casualty; an individual could not deduct her loss (Alphonso, TC Memo 2016-130). The wall at issue was the retaining wall that ran along the Henry Hudson Parkway north of the George Washington Bridge and collapsed onto Riverside Drive on May 12, 2005. Examples of other occurrences that do not qualify as a casualty event:
• Damage to an antique rug by a puppy that is not housetrained.
• Termite or moth damage.
• Destruction of trees, shrubs, or other plants by a fungus, disease, insects, worms, or similar pests.
Determining the Amount of the Loss
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. 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. Sentimental value is not taken into account.
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.
The loss is reduced by any insurance and other reimbursements and by $100 (Code Sec. 165(h)(1)). If a taxpayer has insurance a claim must be made, even if it may cause premiums to increase or the insurance company drops coverage. If a taxpayer has some coverage but no claim is made, no deduction can be taken.
The amount of the loss is not reduced by food, medical supplies, and other forms of assistance received from government or private sources, unless they are replacements for lost or destroyed property (IRS Publication 547).
After determining the amount of the loss from a casualty, then total losses for the year are deductible as an itemized deduction to the extent they exceed 10% of adjusted gross income (AGI) (Code Sec. 165(h)(2)). The casualty loss is an itemized deduction claimed on Schedule A of Form 1040 (i.e., itemizing is required to take a casualty loss deduction). However, the loss is not subject to the phase-out of itemized deductions for high-income taxpayers (Code Sec. 68(c)(3)).
Business or Investment Losses
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 casualty loss deduction can be claimed.
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(i)). 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 for the prior year has already been filed, then an amended return is necessary. In deciding whether to take the loss on the current or prior year return, it usually makes sense to claim it in the year in which adjusted gross income is lower so that a greater portion of the loss is deductible (i.e., more of it exceeds 10% of AGI).
When there is a federal disaster, the IRS may provide some tax relief, such as extending the time for filing returns. For example, the IRS extended the deadlines falling between August 11, 2016 (the date of the storm causing severe flooding in parts of Louisiana) and January 17, 2017, to January 17, 2017 (LA-2016-20, August 15, 2016). Similarly, victims of flooding parts of Texas with filing deadlines between May 26, 2016 (the date of the storm) and October 17, 2016, have an extended due date until October 17, 2016 (HOU-2016-08, June 13, 2016). However, the IRS cannot extend the time for depositing taxes or filing employment and excise tax returns.
Mitigation Payments and Reimbursements
Mitigation payments. Qualified disaster relief payments, such as amounts paid under the Robert T. Stafford Disaster Relief and Emergency Assistance Act or the National Flood Insurance Act to or for the benefit of the owner of any property for hazard mitigation are excludable from gross income. The basis of property is not adjusted for the payments.
FEMA payments under the Individual and Households Program (IHP) to individuals are also tax free. However, a taxpayer who receives a FEMA IHP repair assistance payment or replacement assistance payment must reduce the amount of any casualty loss attributable to the damaged or destroyed residence by the amount of the FEMA IHP payment. In addition, the recipient must reduce the tax basis in the damaged or destroyed residence by the amount of the FEMA IHP repair assistance payment or replacement assistance payment, as well as by the amount of the allowable casualty loss deduction attributable to the damaged or destroyed residence. If the recipient repairs a damaged residence, the cost of repairs ordinarily is capitalized and added to the recipient’s tax basis in the damaged residence.
Reimbursements. 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). 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.
The IRS has more information about disaster assistance and emergency relief for individuals and businesses at https://www.irs.gov/businesses/small-businesses-self-employed/disaster-assistance-and-emergency-relief-for-individuals-and-businesses-1.
Executive Editor Sidney Kess is CPA-attorney, speaker and author of hundreds of tax books. The AICPA established the Sidney Kess Award for Excellence in Continuing Education in his honor, best-known for lecturing to over 700,000 practitioners on tax. Kess is Senior Consultant to Citrin Cooperman & Company and Counsel to Kostelanetz & Fink.