It has been months since Hurricane Sandy unleashed its wrath along the Eastern seacoast.
Many that suffered damages from the storm have not been made whole by FEMA and even less have received full settlements from their insurance companies. Some measure of conciliation is available from Uncle Sam for those that suffered damages. This comes in the form of a tax write-off known as the casualty loss deduction.
The Casualty loss deduction is not new in the tax law. It has been around for decades. This article will explore the tax rules and how to plan for the deduction. The rules differ depending on whether the loss is personal or business related.
Personal Casualty Losses
In general, taxpayers can claim a deduction for personal monetary losses sustained as a result of a casualty or disaster. This deduction is meant to reduce the taxpayer’s tax burden and thereby provide monetary relief through tax savings. Normally, the Casualty loss deduction is claimed in the year the loss is sustained. However, when a casualty loss is sustained in a designated disaster area (such as the area affected by Hurricane Sandy) the loss may be claimed in the year of the loss (2012) or the immediate preceding year (2011).
Personal losses are defined as losses sustained from fires, thefts, storms, car accidents and similar “sudden, unexpected or unusual” events. Hurricane Sandy meets this definition.
How do I calculate my loss deduction? The loss is measured as the lesser of (a) the reduction in property value as a result of the event or (b) the tax basis in the property (usually, the purchase price of the property, plus the cost of improvements). For example, assume a work of art was purchased for $5,000 in 2002 and has appreciated in value to $30,000 right before the storm. After the storm damaged the artwork, its appraised value was reduced to $10,000. The allowed loss would be $5,000 (original purchase price) and not $20,000 (the drop in value).
It may be difficult to document these figures. The burden of proof regarding the loss claimed is on the taxpayer. Original receipts help establish cost. In some cases, appraisals will be needed to establish pre and post loss values.
For real estate, such as a personal residence, determining the loss can be a daunting task, particularly when the property has undergone improvements. Alternative methods for proving the tax loss will be discussed later in this article.
What are the limitations on the deduction? The loss is subject to three limitations. In many cases, these limitations result in no deduction available. First, to the extent the damaged property is insured, the loss must be reduced by actual or reasonably expected insurance reimbursement. Failure to file an insurance claim in the hope of increasing the deduction will not work. The IRS can reduce the loss by the insurance reimbursement that could have been received.
A further limitation is that each casualty must be reduced by $100. This reduction is per “event,” not per item damaged. Thus, if a storm knocks over a tree that damages a car and home, there are three property losses (tree, car and house) and only one reduction of $100.
The third limitation requires combining all casualty losses (under the above guidelines), and reducing the total by 10% of adjusted gross income (AGI). Only the loss amount above this “floor” can be claimed as a deduction. It is this final limitation that often wipes out the deduction. For example, if AGI is $75,000, casualty losses are only deductible to the extent they exceed $7,500 (10% of $75,000).
Unfortunately for many, the Hurricane Sandy losses may exceed these limitations. There is discussion in Congress to have the final two limitations waived for Hurricane Sandy victims, as was the case for some of the previous storms in other parts of the country. This may, in fact, be part of an overall Hurricane Sandy Relief Bill. Stay tuned on that.
Can non-itemizers take the casualty loss deduction? Individual taxpayers who don’t itemize their deductions on their income tax return can’t deduct casualty losses for personal use property. However, in the past, this limitation has been waived. Such a waiver is currently under discussion on Capitol Hill.
Casualty gains. On certain occasions a casualty may ultimately result in a gain, rather than a loss for tax purposes. For instance, a house is purchased for $300,000 and increases in value to $600,000 right before it is destroyed. Its owner receives $600,000 in insurance proceeds; he or she will have a gain of $300,000. In many cases, the tax liability on a casualty gain can be avoided or deferred if a replacement property is purchased within a prescribed period of time.
Calculating a Casualty Loss Deduction
The focus here is on the IRS approved methods for establishing the loss sustained in the storm. More information and guidance is provided in IRS Publication 547.
As discussed earlier, the Casualty loss deduction is measured by the lesser of (a) reduction and fair market value of the property as a result of the event or (b) the purchase price of the property (plus any improvements and renovations to it subsequent to purchase). The key is to establish the decrease in the value of the property, and, for that, an appraisal is needed. In certain cases, other means may also be employed to establish a change in property value.
Use of an appraisal. The appraisal needed to establish the change in property value subsequent to the casualty or theft loss must be done by a qualified and competent appraiser familiar with market conditions relevant to the subject property. This is important in order to establish reduction in value of the property solely because of the event, rather than marketplace conditions. Under IRS guidelines, several important factors must be taken into account for the appraisal to be acceptable. These include the appraiser’s qualifications to do the appropriate research with respect to the property, and his or her knowledge of standard appraisal methodology. These methods include investigating comparable sales and evaluating conditions in the particular area where the casualty event occurred. In certain situations where the property was appraised for purposes of obtaining a federal loan (or a federal loan guarantee) it may be possible to rely on the appraisal to document the change in property value.
Cost of cleaning or making repairs. Many people that have sustained losses to personal property as a result of Hurricane Sandy, will not have appraisals of the property to attest to its value before the storm hit. It thus becomes difficult to prove diminution of property value. The IRS will allow a reasonable method to figure a loss in value by making reference to the cost of cleaning or repairing the damaged property. The cost of repairing damage is not, in and of itself, the measure of the casualty loss. However, what is permissible is the use of the cost of cleaning or repairing storm damage to measure the decrease in the value of the property, provided certain conditions are met. Among them are the requirements that the repairs have actually been made, such repairs were necessary to bring the property back to its condition immediately before the casualty, the amount spent for the repairs were not “excessive” and the repairs only fixed the damage to the property, but did not improve it beyond its original condition.
Landscaping. The cost of restoring landscaping to a home or other real estate to its original condition may also indicate a decrease in property value. It may be possible to measure the loss in value by what is being spent on landscaping, which includes removing destroyed or damaged trees or shrubs, pruning and other measures undertaken to preserve damaged trees and shrubs and replanting, where necessary, to restore the property to its original condition.
Car value. Various available lists of automobile values may be useful indicators of decrease in value of a damaged or destroyed car. It is permissible to use the retail value listed for the automobile in question and modify such value by factors such as mileage on the car before its damage or destruction. These list prices are not official, but they are a useful indication of value and suggestive of comparables for a particular automobile. If the car in question is not listed in any of the published lists, other sources for determining value should be used. A dealer’s offer for the car as a trade-in for a new one is not necessarily a measure of true value.
Items not to consider in determining decrease in value. In accordance with IRS guidelines, there are a number of items that, in general, may not be used to establish a decrease in value of the casualty loss property. These items include the cost to protect the property against the casualty or theft, replacement costs to obtain new property, sentimental value and the cost of photographs or appraisal of damaged property. Incidental expenses such as from personal injury or the cost of temporary housing and car rental are also not to be considered. Once the measure of the casualty loss has been measured, it may be further subject to limitations as discussed earlier.
Business Casualty Losses
Finally, lets address the rules for claiming the Casualty Loss Deduction for property used in a trade or business.
Hurricane Sandy caused major havoc to business owners, the cost of which is still being calculated. Damaged business property included buildings, equipment, motor vehicles and inventory. To claim a business casualty loss, the property must have been used in a trade or business or in the production of income such as rental property. In general, the amount of the Casualty Loss Deduction is the lesser of the decline in the property’s fair market value as a result of the event and its adjusted basis in the hands of its owner (to be discussed later).
There are three important differences between business and personal casualty losses. First, the threshold amounts ($100 and 10% of Adjusted Gross Income or AGI) described earlier do not apply to business property. Second, for real estate, any casualty loss must be calculated separately for each property. For example, if a storm damages both a building and the landscaping in front of the building, each property must be taken into account separately for purposes of calculating the Casualty Loss Deduction. Finally, if the business property is completely destroyed (or stolen), and its adjusted basis is less than its fair market value, immediately prior to the casualty, the loss is calculated solely by considering the adjusted basis of the property less insurance proceeds.
Adjusted Basis: Typically basis is a measure of one’s investment in a particular property. Normally this is the cost of purchasing or creating the property. Property acquired in some other way (gift, inheritance or non-taxable exchange) may have a different basis. A property’s basis then is adjusted periodically to arrive at the final basis amount. These adjustments include increases to reflect additions or permanent improvements to the property and decreases such as earlier losses taken on the property as well as tax deductions for depreciation (which are not necessarily reflective of economic decrease in value). The final adjusted basis amount is important when calculating the available casualty loss deduction.
Inventory: Inventory is property held for sale to customers. This can include widgets in a warehouse, cars on a dealer’s lot or condo units held for sale by a real estate developer. Uninsured inventory losses may be taken into account in one of two ways. A loss on the inventory can be reflected in cost of goods sold as long as opening and closing inventories are properly maintained. The lost inventory (which was included in the beginning inventory prior to the casualty event) should not be included in the ending inventory figures of the business so that the enterprise’s cost of goods sold is higher and decreases gross profit. If this method is used, no casualty loss deduction is allowed. An alternative is to deduct the loss separately as a casualty loss deduction. Under this method, the lost inventory is removed from beginning inventory figures and then claiming a corresponding casualty loss deduction.
Rented Property: If you have rented business property that was damaged or lost in the casualty event, you can claim a casualty loss deduction if you are in fact liable for those damages or lost property items. The cost of repair or replacement of the property, minus any insurance proceeds, is the amount of the casualty loss deduction. On the flip side, the owner of the rented property must reduce his or her casualty loss deduction by the amount paid by the renter to repair or replace the property.
Mixed Use Property: Property used both for business and personal activities must have its basis allocated between each component in order to calculate a personal and then business casualty loss deduction. The rules pertaining to personal and business casualty loss deductions are then applied to each component of the property.
Reimbursement Received After Deducting A Loss: Due to the slow response of many insurance carriers to the claims associated with Hurricane Sandy, it is likely there will be situations where final insurance settlements will take place after the casualty losses have been claimed and reported on income tax returns. If the settlement amounts are different from the amounts used when claiming the deduction, there is no need to amend the tax return. Instead an additional loss or income might have to be reported on the tax return in the year final settlement is reached.
While the rules pertaining to casualty loss deductions are complex, the IRS has issued Publication 584-B to help businesses to identify and evaluate properties damaged or destroyed by events such as Hurricane Sandy. This publication provides helpful guidance in calculating the casualty loss. Checklists included in the Publication lists possible property items included in various categories of property including office furniture and fixtures; information systems; motor vehicles; office supplies; building, building components and land as well as equipment.
In conclusion, taxpayers affected by the recent storm should discuss the casualty loss deduction with their tax advisor as a possible way to receive some relief in the form of tax savings.
For comments or questions, Steven can be reached at firstname.lastname@example.org