Tax Treatment of Casualty Losses and Casualty Gains from Hurricanes Ian, Fiona by Arthur J. Lieberman
Posted on November 02, 2022
Taxpayers are often unaware of how the tax code treats property damage and losses they sustain from natural disasters, such as the recent hurricanes across Florida, the Carolinas and Puerto Rico. Many taxpayers are also surprised to learn that when insurance proceeds or other recoveries exceed the tax basis of damaged property, they may incur a taxable casualty gain. Under these circumstances, it is possible for taxpayers to defer, and in some cases avoid, these tax liabilities when they follow the letter of the law.
When Should Taxpayers Claim Disaster Losses
Taxpayers that 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) have two options for potentially deducting uninsured and unreimbursed casualty losses. They may either 1) claim the losses on a tax return for the year in which the losses occurred (e.g., 2022 for victims of Hurricane Ian and Hurricane Fiona), or 2) elect to deduct the casualty losses on an original or amended return for the tax year immediately preceding the disaster (e.g., 2021 for victims of Hurricane Ian and Hurricane Fiona).
The best option for you will depend on your filing status, your taxable income and other deductions available to you. Claiming a disaster loss in the year before the casualty event occurred will typically result in an expedited tax refund that you may use to pay for immediate repairs and rebuilding expenses. However, deducting the loss in the year in which it occurred may be more favorable if you expect to be in a higher tax bracket that year.
Generally, the IRS provides those affected by federally declared disasters with some form of tax relief. For example, victims of hurricane Fiona in Puerto Rico and Hurricane Ian across Florida, North Carolina and South Carolina now have until February 15, 2023, to meet various tax-filing and -payment obligations with original deadlines occurring between September 17, 2022, (for Hurricane Fiona) or September 23, 2022, for Hurricane Ian) and February 15, 2023. This is welcome news for eligible taxpayers and their tax advisors who now have more time to evaluate their options and decide if they should claim disaster losses on their 2022 tax returns without having to go back and amend their 2021 returns.
Calculating Casualty Losses
For personal-use property, such as a primary residence, taxpayers may calculate their casualty losses by subtracting any insurance proceeds or other forms of reimbursement they receive (or expect to receive) from the lesser of:
- The decrease in the property’s fair market value (FMV) as a result of the casualty; or
- The adjusted basis in the property before the disaster event, which can be calculated as 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.
Generally, you may deduct casualty losses related to personal-use property as an itemized deduction, but you must first reduce these casualty losses by:
- 10 percent of your adjusted gross income, and
- $100 per casualty event.
An exception to this rule exists for casualty losses to businesses and income-producing properties. Under these circumstances, you may determine your deductible losses by subtracting from that amount any insurance proceeds or other forms of reimbursement you 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 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 the living expenses they incur due to the loss of use of their primary homes or their inability to access their homes due to government restrictions.
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 losses they may claim, unless those items replace lost or destroyed property. 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 deductible 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 the 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 by the casualty,
- The amount spent on 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 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 important. Taxpayers should be prepared to demonstrate their ownership of 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 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 a 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 a realized gain only to the extent that they actually reinvest the proceeds in qualified replacement or like-kind property within 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 that has been condemned by local authorities due to storm damage. 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 an 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, he or she generally may exclude from gross income casualty gains of up to $250,000 ($500,000 for married couples) 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 taxpayer defer the excess amount under the involuntary conversion rules discussed above.
Tax rules concerning casualty loss deductions and deferrals of gain on involuntary conversions are complex, but, when properly analyzed and applied, they can provide substantial tax benefits for taxpayers.
As the victims of Hurricane Ian and Hurricane Fiona continue the process of recovery, the professional advisors and accountants with Berkowitz Pollack Brant stand ready to help them navigate through a treacherous field of tax and insurance issues, including assessments of damages to property and businesses, determinations of casualty loss deductions, and tax planning for deferral of gains on involuntary conversions.
About the Author: Arthur J. Lieberman is a director with the Tax Services practice of Berkowitz Pollack Brant Advisors + CPAs, where he works with real estate companies and closely held businesses on deal structuring, tax planning, tax research, tax controversies and compliance issues. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or email@example.com.