Tax Treatment of Casualty Losses and Casualty Gains from the 2017 Hurricanes by Arkadiy (Eric) Green, CPA
Posted on September 16, 2017
Taxpayers are often unaware of how the tax laws treat property damage they sustain and losses they incur from natural disasters, such as the recent hurricanes across Texas, Florida and Puerto Rico. Many taxpayers will also be surprised to learn that, in situations where insurance proceeds or other recoveries exceed the tax basis of the damaged property, they may actually end up with a casualty gain. While casualty gains may be taxable, there are a variety of rules that can be used to defer or even completely avoid tax on these gains in certain cases.
When Should Taxpayers Claim Disaster Losses
When taxpayers suffer personal or business casualty losses in a jurisdiction that the federal government declares to be a disaster area (i.e., eligible for federal disaster relief by FEMA), they will have two options for potentially deducting uninsured and unreimbursed casualty losses:
- Claim the loss on a tax return for the year in which the loss occurred (e.g., 2017 for victims of Hurricanes Harvey and Irma), or
- Elect to deduct the casualty loss on an original or amended return for the tax year immediately preceding the disaster (e.g., 2016 for victims of Hurricanes Harvey and Irma).
The best option will depend on a taxpayer’s individual filing status, taxable income and other deductions available in each tax year. Claiming a disaster loss in the year before the casualty event occurred will typically result in an expedited tax refund, which recipients may use to pay for some immediate repair and rebuilding expenses. However, deducting the loss in the year in which it actually occurred may be more favorable if the taxpayer expects to be in a higher tax bracket for that year.
The IRS usually provides taxpayers affected by federally declared disasters with some tax relief. With regard to victims of Hurricanes Irma and Harvey, the IRS has postponed various tax filing and payment deadlines that occurred starting in September of 2017 until the end of January of 2018. As a result, most businesses and individuals affected by these hurricanes now have until January 31, 2018 to file their 2016 tax returns that were previously extended until September and October of 2017. This relief will provide eligible taxpayers and their tax advisors with some additional time that can be used to evaluate the options and, if so decided, claim the disaster losses on 2016 tax returns without having to go back and amend the 2016 returns.
Calculating Casualty Losses
For personal use property, such as a primary residence, the amount of casualty loss a taxpayer may claim is first determined by subtracting any insurance proceeds or other forms of reimbursement that he or she receives (or expects to receive) from the lesser of:
- The decrease in fair market value (FMV) of the property as a result of the casualty; or
- The adjusted basis in the property before the event (which is generally the owner’s original cost to acquire the property, plus closing costs and capitalized improvements, minus depreciation deductions, previously received insurance and other reimbursements and previous casualty loss deductions).
Individual taxpayers can deduct casualty losses related to personal-use property as an itemized deduction, but they must first reduce these casualty losses by:
- 10 percent of their adjusted gross income, and
- $100 per casualty event.
Casualty losses to business and income-producing properties are not subject to the above $100 and 10 percent rules. Rather, determining these losses requires taxpayers to subtract any insurance proceeds or other forms of reimbursement they receive (or expect to receive), as well as any salvage value from the property’s adjusted basis before the casualty event.
Treatment of Various Payments and Reimbursements
Insurance proceeds that taxpayers receive for insured losses generally reduce the amount of casualty loss deductions they may claim. However, this is not usually the case when taxpayers receive insurance payments to cover living expenses that result from a loss of use of their primary home or when government authorities disallow access to their homes.
Disaster-related assistance that taxpayers receive in the form of food, medical supplies and other forms of assistance typically do not reduce the amount of casualty loss, unless they are replacements for lost or destroyed property. Qualified disaster relief payments, grants and mitigation payments (e.g., payments received under the Robert T. Stanford Disaster Relief and Emergency Assistance Act or the National Flood Insurance Act) are generally excludable from gross income. Still, taxpayers who receive certain qualified disaster-relief payments related to repairs or replacement of destroyed property (e.g., home repair assistance and home replacement assistance payments received from FEMA under the Individuals and Households Program) must reduce the amount of any casualty loss related to the damaged or destroyed residence.
Taxpayers who recover amounts that they deducted as casualty losses in earlier years must report those recovery amounts as gross income in the year of receipt. However, this applies only to the extent that the original casualty-loss deduction actually reduced the taxpayer’s income tax in the year in which it was reported. If the amount of the future year recovery is greater than the amount of the original casualty loss deduction, the taxpayer must generally reduce the basis in the property by the amount of the excess. Additionally, if a required basis reduction exceeds the taxpayer’s remaining basis in the property, the taxpayer may recognize a taxable gain. As discussed in more detail below, some or all of this gain may be excluded or deferred under other provisions of tax code.
Substantiating Casualty Loss Deductions
Property owners have two options for determining the FMV before and immediately after a casualty event. They may hire a professional and competent appraiser who will assess the affected property in comparison with other similar properties. The appraiser should take into consideration the effects of any general market decline that may occur along with the casualty in order to limit the casualty loss deduction to the actual loss resulting from damage to the property.
Alternatively, taxpayers may rely on receipts for repairs to damaged property as evidence of a loss, as long as those repairs meet the following criteria:
- The repairs are necessary to restore the property to its condition before the casualty,
- The repairs are only for the damage suffered in the casualty,
- The amount spent for repairs is not excessive, and
- The value of the property after the repairs is not, due to the repairs, more than its value immediately before the casualty.
Taxpayers who have insurance must file a timely formal claim with their insurance providers, regardless of whether or not it puts them at risk of increased premiums or dropped coverage in the future.
It is recommended that taxpayers expecting to claim casualty losses take photos and/or videos of damaged property (e.g., roofs, windows, landscaping, fences, screening, etc.) as soon as possible after incurring a loss. Such photos and videos may be helpful if the IRS requests proof that property incurred damages as a direct result of a casualty event (such as a flood or a hurricane), as opposed to some form of “progressive deterioration” of property that may have occurred over time, such as steady weakening of a building due to normal wind and weather conditions.
Keeping good records of all repairs and insurance reimbursements is also very important. Taxpayers should be prepared to demonstrate their ownership in the property, the amounts of original basis and adjusted basis in the property, the property’s fair market value before the casualty event and the loss in value resulting from the casualty event.
Be Mindful of Casualty Gains that May be Taxable
When taxpayers receive insurance proceeds or other payments that exceed their adjusted tax basis in damaged and/or destroyed property, they are generally treated as having realized a gain for tax purposes (known as gain from an involuntary conversion). This result will likely surprise many taxpayers who will may feel that they had not gained anything economically. The tax code provides some assistance by allowing property owners to defer some or all of these casualty gains under the involuntary conversion rules. Also, where the property that suffered the casualty loss is a taxpayer’s principal residence, there is an opportunity for the taxpayer to completely avoid some or all of the gain.
To postpone recognition of tax on gain from an involuntary conversion, taxpayers may make a timely Section 1033 election to use insurance proceeds to restore property, reinvest in qualified replacement property that is similar or related in use, or replace involuntarily converted property held for business or investment with “like-kind” property. Generally, taxpayers can defer realized gain only to the extent that they actually reinvest the proceeds in qualified replacement or like-kind property with two years after the close of the first tax year in which they realize any part of the casualty gain, or three years for real property held for productive use in a trade or business and for investment. However, the replacement period is further extended to four years for a taxpayer’s principal residence located in a federally-declared disaster area. The IRS can also grant additional discretionary extension of replacement period (usually limited to a period of one year or less) if the taxpayer applies for an extension before the end of the regular replacement period.
If the property damaged by the casualty is the taxpayer’s principal residence, casualty gains of up to $250,000 ($500,000 for married couples) can generally be excluded from gross income under the rules that apply to sales or exchanges of principal residences. However, if the casualty gain on a home exceeds the amount of the principal residence exclusion, the excess amount may still be deferred under the involuntary conversion rules discussed above.
Tax rules dealing with casualty loss deductions and deferral of gain on involuntary conversions are complex but, when properly analyzed and applied, can provide substantial tax benefits for taxpayers. As the victims of Hurricane Irma and Hurricane Harvey begin the long process of recovery, the professional advisors and accountants with Berkowitz Pollack Brant stand ready to help navigate through a treacherous field of various tax and insurance issues, including assessments of damages to property and businesses, determining the amount of casualty loss deductions, and tax planning for deferral of gains on involuntary conversions.
About the Author: Arkadiy (Eric) Green, CPA, is a director of Tax Services with Berkowitz Pollack Brant, where he works with real estate companies, commercial and residential developers, property management companies, real estate investors and high-net-worth individuals to structure investments and complex transactions for maximum tax efficiency. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at email@example.com.