Deducting Disaster Losses for Individuals

Author: Candice Gerlach, CPA, CFE | April 02, 2021 | 0 Comments | 127 View(s)
https://candicegerlachcpa.com/deducting-disaster-losses-for-individuals/
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We seem to be living in an age of natural disasters.

Uninsured losses to personal non-business property such as your home, personal belongings, or personal car due to a disaster can be deductible. But the rules are complex and not as generous as they used to be.

Only Casualty Losses Are Deductible

Damage to personal property caused by a disaster is deductible only if it qualifies as a casualty loss. A casualty loss is permanent damage, destruction, or loss of property due to an identifiable event that is sudden, unexpected, or unusual.

Deductible casualty losses include but are not limited to

  • earthquakes;
  • fires;
  • floods;
  • car accidents caused by disasters (not by driver negligence);
  • government-ordered demolition or relocation of a building that is unsafe to use because of a disaster;
  • landslides;
  • oil spills;
  • sonic booms;
  • storms, including hurricanes and tornadoes;
  • terrorist attacks;
  •  theft;
  • vandalism; and
  • volcanic eruptions.

Losses due to slow, progressive deterioration of property are not deductible as a casualty loss. For example, the steady weakening or deterioration of a home’s roof due to normal wind and weather conditions is not a deductible casualty loss. But the sudden destruction of a roof due to a tornado is a casualty loss.

For the loss to be deductible, there must be physical damage to property, not merely a decrease in value. Nor is lost revenue a deductible personal casualty loss. Thus, the COVD-19 pandemic has not resulted in deductible personal casualty losses because it did not cause physical damage to property—only to human beings.

Deductible Casualty Losses Come from Federally Declared Disasters

In the past, all types of casualty losses were deductible. But the Tax Cuts and Jobs Act radically changed the rules for 2018 through 2025. During these years, casualty losses to personal property such as your home, personal belongings, or car are deductible only if caused by a federally declared disaster.

All other casualty losses to personal non-business property are not directly deductible during these years—you may deduct them only from casualty gains, if any, as described below.

Example 1. In 2021, a federally declared disaster, a massive wildfire, destroyed your home. You can take a casualty loss deduction for your uninsured losses.

Example 2. In 2021, an accidental house fire due to a faulty fireplace (no federal disaster) destroyed your home. You get no casualty loss deduction.

There are two types of disaster declarations that the U.S. president can make under the Robert T. Stafford Disaster Relief and Emergency Assistance Act: emergency declarations and major disaster declarations. Both can qualify for the casualty loss deduction. Both apply statewide. The Federal Emergency Management Agency (FEMA) maintains a list of declared disasters on its website.

Because of these restrictions, it’s highly advisable to have adequate insurance coverage for your valuable personally owned property—particularly your home. Don’t count on the tax code for any tax deduction if your home or other personal property is damaged or destroyed.

Only Uninsured Disaster Losses Are Deductible

Many, but far from all, casualty losses are covered by insurance. You may deduct casualty losses only to the extent they are not reimbursed by insurance or otherwise.

If a loss is insured, you must file a timely claim, even if it will result in the cancellation of your policy or an increase in premiums. If you don’t file a claim, you get no casualty deduction for the amount of your insurance coverage, but you can deduct the amount of your deductible.

You can’t claim your casualty loss until you know with reasonable certainty whether or not you’ll receive insurance or other reimbursements. Technically, the loss isn’t “sustained” until this time—which could be the year following the casualty event, or even later.

You must reduce the amount of your claimed casualty loss by any insurance recovery you receive or reasonably expect to receive, even if it hasn’t yet been paid.

  • If it later turns out that you receive less insurance than you expected, you can deduct the amount the following year.
  • If you receive more insurance than expected and therefore claimed too large a casualty loss, you include the extra amount as income in the year you receive it.

How to Calculate Casualty Losses

You calculate the deductible amount of a casualty loss by

  • figuring the adjusted basis in the property before the disaster,
  • calculating the decrease in the property’s fair market value (FMV) after the disaster, and
  • subtracting any insurance or other reimbursement received from the smaller of (1) and (2).

The adjusted basis is ordinarily the property’s original cost, plus the cost of permanent improvements. There are various ways to figure the decline in FMV, as discussed below.

Example. A federally declared flood severely damaged Alice’s home, for which she paid $500,000, which is her adjusted basis. Because of the disaster, the house declined in value by $50,000. The insurance company reimbursed Alice $40,000 for the damage. Alice has a $10,000 casualty loss.

You can use IRS Publication 584, Casualty, Disaster, and Theft Loss Workbook (Personal-Use Property) to figure your losses.

Figuring Decline in FMV There are two main ways to determine how much a casualty event reduced your property’s FMV: appraisal or the cost of repair. There are also several optional methods you can use, subject to limitations.

A qualified appraiser’s appraisal is the gold standard for determining the decline in FMV of property due to a casualty.

Appraisals can be expensive. The cost of an appraisal is not part of your casualty loss deduction. And for tax years 2018-2025, you may not deduct the appraisal cost as a miscellaneous itemized deduction.

Floods, wildfires, and other disasters can result in a general decline in property values in the area because potential buyers fear that future similar disasters may occur. Such a reduction in value is not part of a casualty loss and should not be included when an appraiser determines the decline in FMV.

Instead of an appraisal, you can use the cost of repairing the property. But this is acceptable only if

  • the repairs are necessary to bring the property back to its condition before the casualty,
  • the amount spent for repairs is not excessive,
  • the repairs take care of the damage only, and
  • the value of the property after the repairs is not greater than before the casualty.

The general rule is that the repairs must actually be completed when you claim your casualty loss. You can’t use estimates of repairs that are expected to be performed in the future or that might not be performed at all. But the repairs need not be completed when you claim your loss, if you use one of the safe-harbor repair methods described below.

The cost of restoring landscaping to its original condition after a casualty can be a measure of its decrease in FMV. For cars, you can use guides such as the Kelley Blue Book.

Optional Safe-Harbor Methods to Figure Decline in FMV

There are several optional safe-harbor methods to figure the decline in FMV due to a casualty that occurred in 2018 and later. If you use one of the safe harbors, the IRS may not question your valuation. These methods can be especially useful for smaller losses.

If your home (not including a condo or a mobile home) is damaged by a casualty, you may use one of the following optional methods:

Estimated repair cost method. Use the lesser of two repair estimates prepared by licensed contractors. This method is limited to casualty losses of up to $20,000. The repairs need not be completed when you claim your loss.

De minimis method. Prepare a written good-faith estimate of the cost of repairs up to $5,000. Keep documentation showing how you estimated the loss. The repairs need not be completed when you claim your loss.

Insurance method. Use the estimated loss amount contained in reports prepared by your homeowners’ or personal insurance company.

Contractor safe harbor. Use the contract price for repairs prepared by a licensed contractor. You must enter into a binding contract with the contractor to perform the repairs—but the repairs need not be completed when you deduct your loss. This safe harbor is only for property located in federal disaster areas.

Disaster loan appraisal. Use an appraisal prepared for you to obtain a loan from federal funds or a federal loan guarantee. This method is only for property located in federal disaster areas.

If personal belongings are damaged by a casualty, you may use one of the following methods:

  • De minimis method. Make a good-faith estimate of the decrease in FMV up to $5,000. Keep records describing your personal belongings and your method for estimating your loss.
  • Replacement cost. Determine the cost to replace your personal belonging with a new one, and then reduce that amount by 10 percent for each year you owned the belonging (up to nine years). If you use this method, you must use it for all your personal belongings.

General Rule Limiting Personal Casualty Loss Deductions

The general rule for deducting personal casualty losses is that you may take the deduction only if you itemize your personal deductions on IRS Schedule A. In order for you to itemize, your deductible casualty loss and other personal deductions (such as mortgage interest, real estate taxes, and medical expenses) must exceed the standard deduction.

In addition, you may deduct only the amount of the loss that exceeds 10 percent of your adjusted gross income (AGI) for the year. The 10-percent-of-AGI rule greatly limits or eliminates many casualty loss deductions. The higher your income, the less you can deduct.

To add insult to injury, you must also subtract $100 from each casualty or theft you suffered during the year. This reduction applies to each total casualty loss. It does not matter how many pieces of property are involved in an event. Only a single $100 reduction applies.

Example. You suffer a $20,000 casualty loss and have a $100,000 AGI for the year. You may deduct only that portion of the loss that exceeds $10,000 (10 percent x $100,000 = $10,000) minus $100. Your deduction is $9,900.

Special Casualty Loss Limitation Rules for Qualified Disasters

Fortunately, many casualty losses are not subject to the general limitation rules described above. For certain federally declared disasters and certain time periods,

  • the 10-percent-of-AGI threshold is eliminated,
  • the $100 floor is increased to $500, and
  • taxpayers may claim the deduction without itemizing and may increase their standard deduction by the amount of their net disaster losses.

Obviously, these special rules can greatly increase your casualty loss deduction. But these rules apply only to losses due to “qualified disasters.” These are:

  • Disaster losses sustained from January 1, 2020, to February 25, 2021, due to a federally declared major disaster (not including the COVID-19 pandemic); the disaster must have occurred between December 18, 2019, and December 27, 2020.
  • Disaster losses sustained from January 1, 2018, through February 18, 2020, due to a federally declared major disaster; the disaster must have begun from January 1, 2018, through December 20, 2019, and ended by January 19, 2020.
  • Disaster losses sustained in 2017 from Hurricanes Harvey, Irma, or Maria, or in the California wildfires in 2017 and January 2018.

Example. Sally’s Mississippi home suffered $10,000 in uninsured flood damage due to Hurricane Zeta on October 29, 2020. Hurricane Zeta was declared a major federal disaster. Since Zeta was a qualified disaster, Sally may claim a casualty loss of $9,500 ($10,000 – $500). If she does not itemize, she may add this amount to her standard deduction on her 2020 tax return (or claim it for 2019 by filing an amended return).

When to Claim Casualty Losses

You claim a casualty loss by filing IRS Form 4684, Casualties and Thefts, with your return. You may always claim a casualty loss the year it is sustained—this is usually the year it occurs, but can be later if you’re waiting on an insurance claim.

When a loss is caused by a federally declared disaster you also have the option of claiming it for the prior year. This can provide a quick tax refund since you’ll get back part (or even all) of the tax you paid for the prior year. Also, if your loss is subject to the 10-percent-of-AGI limitation, you’ll have a larger deduction if your AGI for the prior year is lower than for the year of the casualty.

You must make an election to claim the loss for the preceding year on Form 4684. Make the election with your original or amended return for the earlier year. You have until October 15 to decide whether to file the election for the prior year.

Net Operating Loss

Now here’s a pleasant surprise. You treat the net amount of your personal casualty loss as if it were incurred in a trade or business, and that means it can create a net operating loss (NOL) for the year.

You carry back an NOL for 2018, 2019, or 2020 five years and obtain a refund of tax paid for those years. You then carry forward any unused amount indefinitely. If you don’t want to carry back the loss, you must elect to relinquish the entire carryback period and carry forward only.

Planning point. In deciding to carry forward only, consider that with the five-year carryback, you have to start five years back. You can’t pick one of the five years to start. For example, with a 2020 loss carryback, you start in 2015 —period.

For 2021 and later years, you can carry the NOL forward indefinitely.

Casualty Gains

It may seem counterintuitive, but it’s not uncommon to have a taxable gain instead of a loss from a casualty. This occurs when the insurance proceeds you receive exceed the adjusted basis in the property.

Example. Martha purchased her home 20 years ago for $200,000; this is her adjusted basis. She receives a $300,000 insurance recovery when the home is destroyed in a hurricane—a federally declared disaster. She has a $100,000 casualty gain.

But you need not include in income insurance proceeds for unscheduled personal property in your home—this is property not specifically listed on a schedule or rider to your basic homeowner’s insurance policy.

A casualty gain is taxable income. But to arrive at your net casualty gain or loss for the year, you may deduct all your casualty losses for the year from your gains. This includes casualty losses that are not due to federally declared disasters. You first deduct losses not from federal disasters and then deduct losses from federal disasters.

Example. The same year Martha had her house destroyed in a hurricane, she had her diamond necklace stolen in a burglary. She suffered a $10,000 theft loss, but the loss was not from a federally declared disaster. She may deduct the $10,000 theft loss from her $100,000 disaster gain.

Avoiding the Disaster Gain

You can treat the casualty as an involuntary conversion and postpone reporting the gain if you spend the reimbursement to repair or replace the property within two years. This time period is extended to four years for your main home if it was in a federally declared disaster area.

If you have a gain because your main home was completely destroyed, you can treat the gain as if it were profit from the sale of your home. If you qualify for the home sale exclusion, you can exclude from income $250,000 of your gain if single or $500,000 if married filing jointly. The destruction does not have to be from a federally declared disaster.

If the destruction exceeds the $250,000/$500,000 limitation, the excess gain may be deferred under the involuntary conversion rules.

The Importance of Documentation

Make sure you can document your casualty losses. You’ll need to have

  • documents showing that you owned each asset you claimed was damaged or destroyed (for example, a deed or receipt);
  • contracts or purchase receipts showing the original cost of the item, plus any improvements you made to it;
  • and evidence of the property’s FMV, such as insurance records, an appraisal, or receipts or estimates for the cost of repair.

Takeaways

Here are six things to know from this article:

1. Physical damage to your home, personal car, or other personal property due to a disaster is deductible only if it constitutes a casualty loss due to a federally declared disaster, such as a hurricane; flood; fire; earthquake; severe winter storm; or other sudden, unusual event. Economic losses, including losses due to COVID-19, are not deductible personal casualty losses.

2. You may deduct personal casualty losses only to the extent they are not reimbursed by insurance. You must file an insurance claim if you have insurance.

3. Personal casualty losses are limited to the lesser of (a) the damaged or destroyed property’s adjusted basis or (b) the decrease in its FMV after the disaster.

4. Unless special rules apply, you may deduct casualty losses only to the extent they exceed 10 percent of your AGI, and you must subtract $100 from each casualty or theft.

5. Casualty losses sustained from January 1, 2020, to February 25, 2021, due to a federally declared major disaster are not subject to the 10-percent-of-AGI floor or the $100 reduction. Such losses are fully deductible over a $500 floor, and the deduction may be added to the standard deduction for non-itemizers.

6. A casualty may result in a taxable gain if the insurance proceeds you receive exceed your adjusted basis in the damaged or destroyed property. Tax on this gain can be postponed under the involuntary conversion rules if you buy replacement property.

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