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The Question:  What are the rules regarding tax deductions for casualty losses?

Objectives

The Internal Revenue Service has the authority to analyze facts and circumstances and make its own interpretation of the tax treatment of the underlying facts and circumstances.  The Internal Revenue Service has three years after it posts the tax return to its records to make its decision about its interpretation of your facts and circumstances.  If the Internal Revenue Service challenge creates a change of 25% or more of the tax the Internal Revenue Service has up to seven years to make it challenge.  Since the Internal Revenue Service’s mission is to collect tax, the usual position of the Internal Revenue Service will be to interpret the facts and circumstance to compute the largest tax possible.  

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The Answer

Possible Internal Revenue Service Points of Challenge

The IRS has the authority to challenge on any point of law, any fact or circumstance or the application of any law or regulation to the fact pattern.  Therefore only two points have been selected to be covered herein.  This document would fail to be a summary if the topic were to be covered in detail.

What is A Casualty Loss?

The IRS, analogizing to fire, storm, and shipwreck, has taken the position that a casualty is "the complete or partial destruction or loss of the taxpayer's property resulting from an identifiable event that is sudden, unexpected and unusual in nature."  You might have a deductible casualty loss whether the damages are to your personal use property or to your business property.  The loss can be used by individuals, sole-proprietors, corporations, partnerships, limited liability companies or other entities.

Casualty losses can result from the destruction of, or damage to your property from any sudden, unexpected, or unusual event such as a flood, hurricane, tornado, fire, earthquake or even volcanic eruption.

If your property is not completely destroyed or stolen, determine your loss from a casualty by first figuring the decrease in fair market value of your property as a result of the casualty event. To do this, you must determine the fair market value of your property both immediately before and immediately after the casualty. An appraisal is the best way to make this determination. Compare the decrease in fair market value with your adjusted basis in the property. The adjusted basis is usually the cost of the property plus or minus certain adjustments. From the smaller of these two amounts, subtract any insurance or other reimbursement you receive or expect to receive. The result is your loss from the casualty.

Up to this point, figuring the deductible loss is the same for both business and personal– use property. If the property was held by you for personal use, you must further reduce your loss by $100. This $100 reduction for losses of personal–use property applies to each casualty or theft event that occurred during the year. The total of all your casualty and theft losses of personal–use property must be further reduced by 10% of your adjusted gross income.The $100 and 10% reductions do not apply to income–producing property (which is also "non–business" property).

In figuring your loss, do not consider the loss of future profits or income due to the casualty.

After you have figured your casualty or theft loss, you must figure how much of the loss you can deduct. If the loss was to property for your personal use or your family's, there are two limits on the amount you can deduct for your casualty or theft loss.

1. You must reduce each casualty or theft loss by $100 ($100 rule).
2. You must further reduce the total of all your losses by 10% of your adjusted gross income (10% rule).

Property used partly for business and partly for personal purposes. When property is used partly for personal purposes and partly for business or income-producing purposes, the casualty or theft loss deduction must be figured separately for the personal-use part and for the business or income-producing part. You must figure each loss separately because the $100 rule and the 10% rule apply only to the loss on the personal-use part of the property.

$100 Rule

After you have figured your casualty or theft loss, you must reduce that loss by $100. This reduction applies to each total casualty or theft loss. It does not matter how many pieces of property are involved in an event. Only a single $100 reduction applies.

Example. A hailstorm damages your home and your car. Determine the amount of loss, as discussed earlier, for each of these items. Since the losses are due to a single event, you combine the losses and reduce the combined amount by $100.

Single event. Generally, events closely related in origin cause a single casualty. It is a single casualty when the damage is from two or more closely related causes, such as wind and flood damage caused by the same storm.

10% Rule

You must reduce the total of all your casualty or theft losses by 10% of your adjusted gross income. Apply this rule after you reduce each loss by $100. If you have both gains and losses from casualties or thefts, see Gains and losses, later in this discussion.

Example 1. In June, you discovered that your house had been burglarized. Your loss after insurance reimbursement was $2,000. Your adjusted gross income is $29,500. You first apply the $100 rule and then the 10% rule. Figure your theft loss deduction as follows.

 

1)	Loss after insurance	$2,000
2)	Subtract $100	100
3)	Loss after $100 rule	$1,900
4)	Subtract 10% ? $29,500 AGI	2,950
5)	Theft loss deduction	-0-

You do not have a theft loss deduction because your loss ($1,900) is less than 10% of your adjusted gross income ($2,950).

Example 2. In March, you had a car accident that totally destroyed your car. You did not have collision insurance on your car, so you did not receive any insurance reimbursement. Your loss on the car was $1,200. In November, a fire damaged your basement and totally destroyed the furniture, washer, dryer, and other items stored there. Your loss on the basement items after reimbursement was $1,700. Your adjusted gross income is $25,000. You figure your casualty loss deduction as follows.

 

		Car	Basement
1)	Loss	$1,200	$1,700
2)	Subtract $100 per incident	100	100
3)	Loss after $100 rule	$1,100	$1,600
4)	Total loss		$2,700
5)	Subtract 10% ? $25,000 AGI		2,500
6)	Casualty loss deduction		$200

Gains and losses. If you had both gains and losses from casualties or thefts to personal-use property, you must compare your total gains to your total losses. Do this after you have reduced each loss by $100.

Losses more than gains. If your losses are more than your recognized gains, subtract your gains from your losses and reduce the result by 10% of your adjusted gross income. The rest is your deductible loss.

Gains more than losses. If your recognized gains are more than your losses, subtract your losses from your gains. The difference is treated as capital gain and must be reported on Schedule D (Form 1040). The 10% rule does not apply to your losses.

Proof of Loss

To deduct a casualty or theft loss, you must be able to prove that you had a casualty or theft. You must be able to support the amount you claim for the loss as discussed next.

Casualty loss proof. For a casualty loss, your records should show all the following.

1. The type of casualty (car accident, fire, storm, etc.) and when it occurred.
2. That the loss was a direct result of the casualty.
3. That you were the owner of the property or, if you leased the property from someone else, that you were contractually liable to the owner for the damage.

Theft loss proof. For a theft loss, your records should show all the following.

1. When you discovered that your property was missing.
2. That your property was stolen.
3. That you were the owner of the property.

Only Items Damaged are Deductible

The deductible amount should include losses on only those items which were damaged in the incident.  The damage report and the insurance records showing computation of damages would be used by the Internal Revenue Service to determine which items were damaged and the replacement cost of those items.  The costs of cleanup and repair of physical damage are not part of a casualty loss.

On your side —  The second method used to measure the amount of damage to property caused by a casualty is the cost of repairing the property. Reg. Section 1.165-7(a)(2)(ii). This method can only be used when the property is actually repaired. The taxpayer must show that the repairs were necessary to restore the property to its condition immediately before the casualty and that the amount spent for the repairs is not excessive. The cost of repairs is taken into account only to the extent that the property is restored but not improved; the repairs should not increase the property's value compared to what it was immediately before the casualty. Reg. Section 1.165-7(a)(2)(ii).

Challenge to the Decrease in Fair Market Value

The Internal Revenue Service many times will challenge a fact pattern based upon “opinions”.  One of the limits to the deductible loss is the decrease in “Fair Market Value”.  If the Internal Revenue Service should choose (and we do not know that it will) to be belligerent then it could make a challenge based upon this limit.  The Internal Revenue Service would ask “What is the market before and the market value after the incident?”.   The Internal Revenue Service might attempt to argue the decrease in market value was the same as the insurance reimbursement, and therefore disallow the deduction (except for the deductible).

On your side — In order to meet this type of challenge we would argue for you the following:

The cost of repairs is not a limit on the amount of the loss; it is a basis for a computation of the amount of loss. The amount of the loss can be greater than the cost of repairs if the property is not restored to its value before the casualty. Brush v. Commissioner, T.C. Memo. 1962-124.

Solutions

Solutions are dependent upon facts & circumstances, law and the objectives.  These elements vary from one time to another, from one circumstance to another and from person or entity to another.

Kit to Prepare for Your Adviser

Casualty Losses Fact Gathering Sheet (pdf)

Casualty or Theft Losses A Fact Gathering Sheet

4684 Casualty Loss Form The IRS Form

Losses You May Deduct

You may deduct losses from fire, storm, shipwreck, or other casualty, or theft (for example, larceny, embezzlement, and robbery).

If your property is covered by insurance, you must file a timely insurance claim for reimbursement of your loss. Otherwise, you cannot deduct the loss as a casualty or theft loss. However, the part of the loss that is not covered by insurance is still deductible.

Related expenses.   The related expenses you have due to a casualty or theft, such as expenses for the treatment of personal injuries or for the rental of a car, are not deductible as casualty or theft losses.

Costs for protection against future casualties are not deductible but should be capitalized as permanent improvements. An example would be the cost of a levee to stop flooding.

Losses You May Not Deduct

• Money or property misplaced or lost.
• Breakage of china, glassware, furniture, and similar items under normal conditions.
• Progressive damage to property (buildings, clothes, trees, etc.) caused by termites, moths, other insects, or disease.

Gain on Reimbursement

If the amount you receive in insurance or other reimbursement is more than the cost or other basis of the property, you have a gain. If you have a gain, you may have to pay tax on it, or you may be able to postpone the gain.

Do not report the gain on damaged, destroyed, or stolen property if you receive property that is similar or related to it in service or use. Your basis in the new property is the same as your basis in the old property.

Any tangible replacement property held for use in a trade or business is treated as similar or related in service or use to property held for use in a trade or business or for investment if:

• The property you are replacing was damaged or destroyed in a disaster and
• The area in which the property was damaged or destroyed was declared by the President of the United States to warrant Federal assistance because of that disaster.

Generally, you must recognize the gain if you receive unlike property or money as reimbursement. But you generally can choose to postpone all or part of the gain if, within 2 years of the end of the first tax year in which any part of the gain is realized, you purchase:

• Property similar or related in service or use to the damaged, destroyed, or stolen property or
• A controlling interest (at least 80%) in a corporation owning such property.

To postpone all of the gain, the cost of the replacement property must be equal to or more than the reimbursement you received for your property. If the cost of the replacement property is less than the reimbursement received, you must recognize the gain to the extent the reimbursement exceeds the cost of the replacement property.

If the replacement property or stock is acquired from a related person, gain generally cannot be postponed by:

• Corporations (other than S corporations);
• Partnerships more than 50% owned by one or more corporations (other than S corporations); or
• All other taxpayers, unless the aggregate realized gains on the involuntarily converted property are $100,000 or less for the tax year. (This rule applies to partnerships and S corporations at both the entity and partner or shareholder level.)

For details, see section 1033(i).

For details on how to postpone the gain, see Pub. 547, Casualties, Disasters, and Thefts (Business and Nonbusiness).

If your main home was located in a Presidentially declared disaster area, and that home or any of its contents were damaged or destroyed due to the disaster, special rules apply. See Gains Realized on Homes in Disaster Areas on page 2.

When To Deduct a Loss

Deduct the part of your casualty or theft loss that is not reimbursable in the tax year the casualty occurred or the theft was discovered. However, a disaster loss and a loss from deposits in insolvent or bankrupt financial institutions may be treated differently. See Disaster Losses below and Special Treatment for Losses on Deposits in Insolvent or Bankrupt Financial Institutions on
page 2.

If you are not sure whether part of your casualty or theft loss will be reimbursed, do not deduct that part until the tax year when you become reasonably certain that it will not be reimbursed.

If you are reimbursed for a loss you deducted in an earlier year, include the reimbursement in your income in the year you received it, but only to the extent the deduction reduced your tax in an earlier year.

See Pub. 547 for special rules on when to deduct losses from casualties and thefts to leased property.

Disaster Losses

A disaster loss is a loss that occurred in an area determined by the President of the United States to warrant Federal disaster assistance.

You may elect to deduct a disaster loss in the tax year immediately prior to the tax year in which the disaster occurred as long as the loss would otherwise be allowed as a deduction in the tax year it occurred.

This election must be made by filing your return or amended return for the prior year, and claiming your disaster loss on it, by the later of:

• The due date for filing your original return (without extensions) for the tax year in which the disaster actually occurred or
• The due date for filing your original return (including extensions) for the tax year immediately prior to the tax year in which the disaster actually occurred.

You may revoke your election within 90 days after making it by returning to the IRS any refund or credit you received from the election. If you revoke your election before receiving a refund, you must repay the refund within 30 days after receiving it.

On the return on which you claim the disaster loss, specify the date(s) of the disaster and the city, town, county, and state in which the damaged or destroyed property was located.

Note:   To determine the amount to deduct for a disaster loss, you must take into account as reimbursements any benefits you received from Federal or state programs to restore your property.

If your home was located in a disaster area and your state or local government ordered you to tear it down or move it because it was no longer safe to use as a home, the loss in value because it is no longer safe is treated as a disaster loss. The order for you to tear down or move the home must have been issued within 120 days after the area was officially declared a disaster area.

For purposes of figuring the disaster loss, use the value of your home before you moved it or tore it down as its fair market value (FMV) after the casualty.

Gains Realized on Homes in Disaster Areas

The following rules apply if your main home was located in an area declared by the President of the United States to warrant Federal assistance as the result of a disaster, and the home or any of its contents were damaged or destroyed due to the disaster. These rules also apply to renters who receive insurance proceeds for damaged or destroyed property in a rented home that is their main home.

• No gain is recognized on any insurance proceeds received for unscheduled personal property that was part of the contents of the home.
• Any other insurance proceeds you receive for the home or its contents is treated as received for a single item of property, and any replacement property you purchase that is similar or related in service or use to the home or its contents is treated as similar or related in service or use to that single item of property. Therefore, you can choose to recognize gain only to the extent the insurance proceeds treated as received for that single item of property exceed the cost of the replacement property.
• If you choose to postpone any gain from the receipt of insurance or other reimbursement for your main home or any of its contents, the period in which you must purchase replacement property is extended until 4 years after the end of the first tax year in which any part of the gain is realized.

Example.   Your main home and its contents were completely destroyed in 2001 by a fire in a Presidentially declared disaster area. In 2001, you received insurance proceeds of $200,000 for the home, $25,000 for unscheduled personal property in your home, $5,000 for jewelry, and $10,000 for a stamp collection. The jewelry and stamp collection were kept in your home and were scheduled property on your insurance policy. No gain is recognized on the $25,000 you received for the unscheduled personal property. If you reinvest the remaining proceeds of $215,000 in a replacement home, any type of replacement contents (whether scheduled or unscheduled), or both, you can elect to postpone any gain on your home, jewelry, or stamp collection. If you reinvest less than $215,000, any gain is recognized only to the extent $215,000 exceeds the amount you reinvest in a replacement home, any type of replacement contents (whether scheduled or unscheduled), or both. To postpone gain, you must purchase the replacement property before 2006. Your basis in the replacement property equals its cost decreased by the amount of any postponed gain.

For details on how to postpone gain, see Pub. 547.

Special Treatment for Losses on Deposits in Insolvent or Bankrupt Financial Institutions

Do the records support an entry on my tax return?

Records you could use to verify the information you report on your tax return should be kept as long as an audit is possible. The IRS normally has 3 years to audit a return. That period, called a statute of limitations, begins the day the return is filed, or the due date if the return is filed earlier, and can be extended for a number of reasons. Examples include 2 to 3 years following additional claims filed later by you, or a total of 6 years for understating your income by more than 25 percent. For records that would help you through an audit, a conservative approach is to keep them for 7 years.

Are the records connected to business property?

Some records establish the basis (or value) of property for depreciation deductions or for calculating the gain or loss at sale. These records should be held for as long as you have the property plus the same 7 years as above.

Do the records support deductions that will be applied to other tax years?

Sometimes deductions, such as limited charitable contributions, casualty losses, or net operating losses, are carried forward or backward and applied to other tax years. Records that substantiate the original loss or expense should be retained for as many years as you are carrying forward the deduction plus the same 7 years as above.

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