Disasters result from natural causes, such as storms, floods, fires, and earthquakes, and from human activity, such as riots and terrorist attacks. Unfortunately, disasters have become all too common. In the first eight months of 2016, the Federal Emergency Management Agency (FEMA) had already designated 31 events as federal disasters (http://bit.ly/2eHHAA7). Property losses from such events may be covered by insurance, which may provide some compensation to individuals and businesses for property damage and destruction, assuming the type of event is covered by the policy. Such coverage should be reviewed, along with the applicable tax rules, to see what can be done to help financially with recovery in case disaster strikes.
Reviewing Insurance Coverage
Individuals and businesses should have the right type of coverage to protect their property. The following types of coverage are useful in disasters (or, as the insurance industry calls them, “casualty events”):
- Flood insurance. Coverage is obtained through the National Flood Insurance Program (https://www.floodsmart.gov/flood-smart/) for properties located within flood zones. There is residential and commercial coverage available.
- Homeowners policy. Check the policy for events not covered. Most policies cover fire and smoke, even if resulting from a terrorist attack or a civil riot.
- Business owners policy (BOP). Such policies likely will not include coverage for losses resulting from terrorism; a separate policy or rider is needed for coverage in this event. Coverage under this separate policy or rider is afforded only if the attack is declared by the Secretary of the Treasury to be a “certified act.”
- Business interruption insurance. This coverage provides the proceeds to pay overhead expenses, such as rent, utilities, and payroll. There does not have to be any physical damage; all that is required is the inability to use the premises because of a casualty event.
For most residential and business policies, certain types of disasters are usually not covered and may not be coverable, including nuclear, biological, and chemical events. Acts of war are routinely excluded.
Determining a Casualty Event
Individuals usually cannot deduct losses for damage or destruction to personal-use property. There is, however, an exception that allows for a deductible loss resulting from a casualty. A nonbusiness casualty event for individuals seeking to deduct uninsured losses includes a fire, storm, shipwreck, or other casualty. The meaning of “other casualty” has been developed by case law to mean a sudden, unexpected, or unusual event. Examples of other casualties include the following:
- Government-ordered demolition or relocation of a home that is unsafe to use because of a disaster
- Mine cave-ins
- Sonic booms
- Storms, including hurricanes and tornadoes
- Terrorist attacks
- Acts of vandalism
- Volcanic eruptions.
Progressive deterioration, however, is not a casualty event for tax purposes because the destruction is gradual rather than sudden. In one recent case, the collapse of a retaining wall that had been deteriorating for an estimated 25 years was held to be progressive deterioration and not a casualty (Alphonso v. Comm’r, TC Memo 2016-130). The fact that there had been rain just prior to the collapse did not transform it into a casualty.
The following are examples of other occurrences that do not qualify as casualty events:
- Damage to an antique rug by a puppy that is not house-trained
- Destruction of trees, shrubs, or other plants by a fungus, disease, insects, worms, or similar pests
- Moth or termite damage.
Determining the Amount of the Loss
For nonbusiness (personal use) property, the loss is the lesser of the adjusted basis of the property (typically, cost) or the difference between the property’s value before and after the disaster. Fair market value is usually ascertained by an appraisal made by a “competent” appraiser [Treasury Regulations section 1.165-7(a)(2)(i)]. The appraisal must take into account the effects of any general market decline affecting undamaged as well as damaged property, which may occur simultaneously with the casualty event. Sentimental value for heirlooms and keepsakes is not taken into account. Also disregarded is a general decline in the market value of property because it is located in or near an area that suffered a casualty event; only actual casualty damage can be considered.
In lieu of obtaining an appraisal, the cost of repairs to the damaged property can be used as acceptable evidence of the loss in value if—
- the repairs are necessary to restore the property to its pre-casualty condition,
- the amount spent for repairs is not excessive,
- the repairs relate only to the damage suffered in the casualty, and
- the value of the property after the repairs does not exceed its value immediately before the casualty [Treasury Regulations section 1.165-7(a)(2)(ii)].
The loss is reduced by any insurance and other reimbursements, and also by $100 per event [Internal Revenue Code (IRC) section 165(h)(1)]. If a taxpayer has insurance, a claim must be made, even if submitting a claim may cause increased premiums or dropped coverage.
The amount of the loss is not reduced by food, medical supplies, or other forms of assistance received from government or private sources, unless they are replacements for lost or destroyed property (IRS Publication 547, Casualties, Disasters, and Thefts).
CHECKLIST FOR RECOVERING FROM A DISASTER
- ___ Have I reviewed my existing insurance coverage for possible disasters?
- ___ Do I have a plan for my family’s communication, in case of a disaster?
- ___ Do I have a disaster preparedness plan for my business?
- ___ Do I have a list on hand of important contact information following a disaster (insurance agent, FEMA, SBA)?
- ___ Do I fully understand the need for records and appraisals following a disaster so I can submit claims and take tax write-offs?
- ___ Have I backed up key records to the cloud?
- ___ Do I fully understand the difference in tax rules for losses to personal-use property versus business or investment property?
After determining the amount of the loss from a casualty, the total losses for the year are deductible as an itemized deduction to the extent they exceed 10% of adjusted gross income (AGI) [IRC section 165(h)(2)]. The casualty loss is an itemized deduction claimed on Schedule A of Form 1040, so itemizing is necessary in order to take a casualty loss deduction. A casualty loss deduction is not, however, subject to the phaseout of itemized deductions for high-income taxpayers [IRC section 68(c)(3)].
Business or Investment Losses
Losses to business or investment property are fully deductible. The limits for personal-use property (i.e., the $100 reduction and 10%-of-AGI threshold) do not apply. For property that is totally destroyed and not covered by insurance, the loss is the property’s adjusted basis. When property has been expensed or fully depreciated, there is zero basis, so no casualty loss deduction can be claimed.
There are two ways to treat the damage of destruction of inventory: It can be deducted through the increase in the cost of goods sold by properly reporting opening and closing inventories. If this option is used, then any insurance or other recovery is included in gross income. Or, the loss can be deducted separately and the affected inventory eliminated from the cost of goods sold by making a downward adjustment to opening inventory or purchases. The loss, in this instance, is reduced by any insurance or recovery (i.e., the recovery is not taxable).
If the loss occurs within an area declared eligible for federal disaster relief by FEMA, affected taxpayers may claim the loss on a tax return for the year of the casualty event or for the prior year [IRC section 165(i)]. Claiming the loss for the prior year entitles a taxpayer to receive a tax refund, which can be used to help rebuild after the disaster. If the return for the prior year has already been filed, an amended return is necessary. The IRS lists areas qualifying for this disaster relief at http://www.irs.gov/uac/Tax-Relief-in-Disaster-Situations.
When there is a federal disaster, the IRS may provide some general tax relief, such as extending the time for filing returns. Recently, for example, the IRS extended all deadlines falling between August 11, 2016 (the date of the storm causing severe flooding in parts of Louisiana), and January 17, 2017, to January 17, 2017 (LA-2016-20, August 15, 2016). Similarly, victims of flooding in parts of Texas with filing deadlines between May 26, 2016 (the date of the storm), and October 17, 2016, have an extended due date of October 17, 2016 (HOU-2016-08, June 13, 2016). The IRS cannot, however, extend the time for depositing taxes or filing employment and excise tax returns.
If insurance proceeds or other recoveries are greater than the tax basis in the damaged or destroyed property, a gain results for tax purposes, even though the taxpayer feels like there has been an economic loss. For example, if there is a recovery for fully depreciated business property, the result is a gain from an involuntary conversion.
Tax on the gain can be postponed by reinvesting in replacement property or using the proceeds to restore property, within a set period. The basic replacement period ends two years after the close of the year in which the gain is realized. The period for a main home and contents in a disaster area, however, is four years. The IRS may grant an extension of the replacement period of not more than one year. An extension may be granted, for example, where property is being constructed but cannot be completed within the replacement period. The high market value or scarcity of replacement property, however, is usually not sufficient reason for an extension.
The basis of the replacement property is generally the same as that of the property that was replaced (IRC section 1033). Therefore, the gain from the involuntary conversion will be recognized when the replacement property is disposed of in a taxable transaction.
Mitigation Payments and Reimbursements
Disaster victims may receive payments other than insurance proceeds. Some of these payments are taxable, while others are tax-free.
Qualified disaster relief payments, such as amounts paid under the Robert T. Stafford Disaster Relief and Emergency Assistance Act or the National Flood Insurance Act for hazard mitigation, are excludable from gross income. The basis of the property is not adjusted for the payments.
FEMA payments under the Individuals and Households Program (IHP) to individuals are also tax free. A taxpayer who receives a FEMA IHP repair assistance payment or replacement assistance payment, however, must reduce the amount of any casualty loss attributable to the damaged or destroyed residence by the amount of the payment. In addition, the recipient must reduce the tax basis in the damaged or destroyed residence by the amount of the payment, as well as by the amount of the allowable casualty loss deduction attributable to the damaged or destroyed residence. If the recipient repairs a damaged residence, the cost of repairs is ordinarily capitalized and added to the recipient’s tax basis in the damaged residence.
If a taxpayer claims a casualty loss deduction and, in a later year, receives reimbursement for the loss, the taxpayer reports the amount of the reimbursement in gross income in the year it is received to the extent the casualty loss deduction reduces the taxpayer’s income tax in the year in which the deduction was reported. The taxable amount is determined under the tax benefit rule (IRC section 111). If the reimbursement exceeds the amount of the casualty loss deduction, the basis in the property is reduced by the amount of the excess. Any such excess that exceeds the remaining basis in the property is included in income as gain, unless such gain is excludable from income or its recognition can be deferred as gain from an involuntary conversion under IRC section 1033, as above.
Disaster Recovery Plans
Individuals and businesses should consider what would happen to vital tax and financial information in the event of a casualty event. What financial and other assistance is available? Disaster recovery plans should be made for families or businesses. Families should discuss communication plans if separated because of a casualty event, and understand how to access necessary financial information (e.g., insurance policies, bank accounts). Businesses need contingency plans for operations in case a disaster disrupts them. The following resources can help in the planning process:
- The AICPA’s Casualty Loss and Disaster Relief (http://bit.ly/2f2txZ3), including a Casualty Loss Practice Guide for members of the Tax Section
- The American Red Cross’s Disaster Recovery Guide (http://rdcrss.org/2fDjnjs), which includes information on recovering financially
- Ready.gov’s Business Continuity Plan (http://bit.ly/2emhAtk), which includes a business continuity impact analysis
- Ready.gov’s Recovering from Disaster (http://bit.ly/2fpLa1Y) for individuals.
In addition, the IRS has provided some tips for safeguarding records (http://bit.ly/2emkyxM):
- Back up records to the cloud.
- Scan paper records for easy storage.
- Document valuables. Photos, appraisals, and other documentation should be collected and protected (e.g., backed up to the cloud).
The IRS has more information about disaster assistance and emergency relief for individuals and businesses at http://bit.ly/2f2rkwL.