As those affected go through the process of rebuilding or replacing damaged property it is critical that as much documentation as possible is kept. This documentation includes the tax basis (cost) of the property damaged or destroyed, its fair market value (“FMV”) immediately before and after the casualty (supported by before and after photographs), the cost of repairs, and the residual or salvage value of the property.
If it is your business that sustained the loss, other costs may also be incurred because of a natural disaster but it is important to note that they might not be afforded casualty loss treatment (e.g., reversing vacation pay accruals, incrementally higher costs of operations related to the use of outside contractors, utilization of alternative plants, changes to logistic operations, etc.). However, these other costs may necessitate a revision to tax planning, estimated tax payments, and quarterly income tax accruals.
Appraisals can be used to establish the amount of a casualty loss deduction. Although most of us do not have a recent appraisal on our property, the Internal Revenue Code allows taxpayers to have an appraisal done after the casualty event that can establish what the value was prior to its occurrence. An appraisal can also be done to determine the value of the property after the storm but it is important that the appraiser not factor in any temporary declines in value due to the casualty event. The appraiser must assume that the negative stigma brought on by the event will wear off over time. IRS Publication 547 details several factors that are important when evaluating the accuracy of an appraisal such as:
We may also be able to use an appraisal that was used to get a federal loan (or a federal loan guarantee) as the result of a federally declared disaster to establish the amount of the loss.
The costs incurred to clean up or make repairs can also be used to determine the decrease in FMV if we meet all the following conditions outlined in Publication 547:
When determining the loss, we also need to consider any insurance payout or other reimbursement received. We don’t have a casualty loss to the extent we are reimbursed. If the insurance reimbursements exceed the loss, a casualty gain can result. If this occurs there are ways to exclude or postpone the tax on the gain. The IRS can also deny or reduce a casualty loss if it is determined that we failed to submit an insurance claim that we were entitled to.
The Internal Revenue Code has limits on casualty losses claimed by individuals that are not related to income-producing property (e.g., rental home). However, with regard to victims of Hurricanes Harvey, Irma and Maria, the President recently signed into law the Disaster Tax Relief and Airport Extension Act of 2017. This act removed the 10% AGI limitation discussed below, the requirement to itemize deductions in order to claim a casualty loss and it increases the amount required to reduce each loss occurrence from $100 to $500.
If you are not located in the aforementioned disaster areas the following limitations apply. For each casualty to personal use property, the loss amount must be reduced by $100. This reduction is per “event,” not per item damaged. Thus, if a storm knocks over a tree that damages your car and home, you have three property losses (tree, car, house) and only one reduction. Certain casualty loss deductions are further limited to the excess over 10% of your adjusted gross income (AGI).
For example, let’s assume that the initial cost basis plus improvements made to your residence was $275,000. After the storm, you received $75,000 in insurance reimbursements. Your appraisal valued the property at $480,000 before and $290,000 after the storm indicating a decrease in FMV of $190,000 ($480,000 – $290,000). The casualty loss rules allow you to claim the lesser of cost basis or the decrease in FMV, which in this case is $190,000. After offsetting the loss with your $75,000 of insurance reimbursements and the $100 per event threshold, your net loss is $114,900 ($190,000 – $75,000 – $100). If we assume your AGI is $200,000, the application of the 10% AGI limitation would result in a deductible loss of $94,900 ($114,900 – ($200,000 x 10%)). Note that if the loss related to business property, your cost basis would be reduced for any depreciation previously claimed, however, the $100 per event and 10% of AGI thresholds don’t apply.
As previously mentioned, when you receive insurance or other reimbursements that are more than your adjusted basis in the property, a gain is realized. If you have a gain resulting from the destruction of your primary residence, you generally can exclude the gain from your income as if the home was sold. The exclusion would be up to $250,000 (up to $500,000 if married filing jointly). This exclusion generally only applies if you owned and lived in the property as your main home for at least 2 years during the 5-year period ending on the date it was destroyed.
If you have a casualty gain, you can also postpone reporting all the gain if you spend the reimbursements to restore the property. The following example is from IRS Publication 547:
“In 1970, you bought an oceanfront cottage for your personal use at a cost of $18,000. You made no further improvements or additions to it. When a storm destroyed the cottage this January, the cottage was worth $250,000. You received $146,000 from the insurance company in March. You had a gain of $128,000 ($146,000 ? $18,000). You spent $144,000 to rebuild the cottage. Since this is less than the insurance proceeds received, you must include $2,000 ($146,000 ? $144,000) in your income.”
The gain can also be postponed if you buy replacement property within two years after the close of the first tax year in which the gain is realized or within four years if the gain resulted from your main home that was in a federally declared disaster area.
If you are an individual taxpayer located in an area that was declared a federal disaster area, you can either deduct the loss on your 2017 return or you also have the option of amending your 2016 return. Amending your 2016 return could result in receiving the refund faster but it is important to evaluate your income and deductions in both years to determine which year would result in the largest refund.
If you have been affected by the recent hurricanes and would like more information about this topic, please contact a member of our Tax Services Group by filling out the form below. Through our vast resources, Withum can assist individuals, businesses and governmental bodies navigate the recovery process in many ways. This could include the preparation of property damage claims and/or business interruption reports, defense of such damage claim reports, monitoring clean-up and construction operations and navigating the insurance and FEMA process.