Tax Relief for California Wildfire Victims

The California wildfires that broke out on January 7, 2025, have caused tremendous devastation to individuals and businesses alike. More than 29 people have died, and the wildfires have damaged more than 40,000 acres of land in and around Los Angeles. The fires have destroyed more than 12,000 homes and businesses and more than 180,000 people were under evacuation orders during the worst of it.

On January 8, 2025, President Biden declared the California wildfires a major disaster as of January 7, 2025. Additionally, FEMA released guidance that federal funding would be available to affected individuals and businesses in Los Angeles County.

The federal tax laws have various provisions that can provide relief to affected taxpayers. This article summarizes the federal tax relief that is available.

The IRS announced on January 10, 2025, that individuals and businesses in southern California that were affected by the wildfires will now have until October 15, 2025, to file various individual and business tax returns and to make tax payments. The tax relief postpones various tax filing and payment deadlines from January 7, 2025, through October 15, 2025. The new October 15^th deadline applies to:

Relief also was provided to eliminate penalties for failing to make payroll and excise tax payments due on or after January 7, 2025, and before January 22, 2025.

The IRS provided additional relief to affected individuals who participate in a retirement plan or IRA. Affected individuals can take a special disaster distribution without incurring the 10% early distribution tax and they can spread the income over three years. Also, they may be eligible to take a hardship withdrawal depending on the specific rules of the retirement plan or IRA.

Individuals can deduct disaster-related losses to the extent they are not reimbursed by insurance. For example, the amount of an individual’s casualty loss deduction relating to the loss of a home is equal to the lesser of (i) the individual’s adjusted cost basis in the home and (ii) the decline in value of the home due to the wildfires, less any insurance recovery. Note the tax law does not allow individuals to deduct the fair market value of their homes, which in many cases exceed their cost, particularly in southern California. For taxpayers whose homes have appreciated in value, they may not even be able to claim a casualty loss deduction because the insurance proceeds they receive to rebuild their home (i.e., from replacement cost insurance) are likely to exceed their tax basis in the home. Even if taxpayers can claim casualty loss deductions, they may choose not to because subsequent recoveries can lead to ordinary income under the tax benefit rule, but this is a nuanced point that should be considered carefully in conjunction with a qualified tax advisor.

There is a special rule that normally limits the amount of a personal casualty loss to an amount that exceeds 10% of an individual’s adjusted gross income. This rule would not apply, and a more generous $500 limitation would apply if the California wildfires constitute a qualified disaster under a new law enacted on December 12, 2024. The IRS takes the position that a qualified disaster must be declared by the President between January 1, 2020, and February 10, 2025, and the incident period of the disaster must have begun on or after December 28, 2019, and on or before December 12, 2024. The California wildfires began in January 2025 and would not meet the incident period deadline. Thus, Congressional action is required to eliminate the 10% floor for individual casualty loss deductions relating to the California wildfires.

The tax law also provides some flexibility regarding the timing of a casualty loss deduction. Casualty losses generally are deductible on the tax return that includes the year of the loss, which here would be an individual’s 2025 tax return that is due April 15, 2026. However, in the case of federally declared disasters, which includes the California wildfires, individuals can elect to deduct casualty losses on their 2024 tax returns. This election provides quicker access to refunds, and individuals will have extra time to file the election – it can be filed on Form 4684, Section D, Part 1, at any time on or before October 15, 2026. Taxpayers should write the FEMA declaration number – 4856-DR – on the tax return claiming the loss.

The portion of any casualty loss that may be reimbursed by insurance cannot be deducted until it can be ascertained with reasonable certainty that the insurance reimbursement will be received. For example, if an individual lost a home that cost $1 million and there is an insurance claim for $800,000, then the individual can only deduct $200,000 according to the rules discussed above. If the insurance company ultimately pays only $700,000, then an additional deduction of $100,000 can be taken at that time.

Qualified disaster relief payments (QDRPs) generally are excluded from gross income. This includes QDRPs received for reasonable and necessary personal, family, living, or funeral expenses, rental payments for temporary replacement housing or replacement transportation, as well as for the repair or rehabilitation of a home or for the repair or replacement of its contents. In the case of a federally declared disaster, taxpayers can also exclude from gross income insurance proceeds that compensate for the loss of personal property in a primary residence.

Otherwise, insurance proceeds generally are taxable to the extent they exceed a taxpayer’s adjusted basis in the property destroyed. Basis includes the cost to acquire the property and the cost of any capitalized improvements to the property, such as a major renovation. Even though the casualty gain would be taxable as capital gain, taxpayers can avail themselves of an exclusion from gross income if the property destroyed was their principal residence. This applies to exclude gain in an amount up to $250,000 for single filers and $500,000 for married taxpayers filing jointly. Taxpayers also can file an election to defer (as opposed to eliminate) tax on casualty gain under section 1033, dealing with involuntary conversions, provided the insurance proceeds are reinvested within 4 years after the close of the calendar year in which the disaster occurs.

Navigating the casualty loss tax rules can be complex, and often, there are conditions and exceptions that apply. Ensure your tax preparer is up to date on the latest information to maximize the tax benefits available to you.