Internal Revenue Code (IRC) section 165(c)(3) defines a casualty event to be a “fire, storm shipwreck, or other casualty.” As usually happens with ambiguous language in the the tax code, IRS Publication 547 attempts to clarify the definition of a casualty as the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual (http://bit.ly/2J99p3m). Some examples provided include car accidents, earthquakes, fires, floods, terrorist attacks, and storms (including hurricanes and tornadoes). This article examines the prior rules surrounding the casualty loss deduction and how these rules have changed under the Tax Cuts and Jobs Act (TCJA).
Under the prior law, an individual taxpayer could deduct a loss if it was connected with a trade or business or a transaction entered into for a profit motive under IRC section 165(c)(1) or (c)(2). If it was not connected with a trade or business, it could still be deducted if it met the definition of a personal casualty loss under IRC sections 165(a) and 165(h). The loss could be deducted if it was not compensated for by insurance or other reimbursement. The amount of the deductible loss was the lesser of 1) the taxpayer’s adjusted basis in the property or 2) the decrease in fair market value of the property as a result of the casualty, less any insurance or other reimbursement received.
There were additional limitations: a $100 limitation per casualty [IRC section 165(h)(1)] and an overall limitation of 10% of the taxpayer’s adjusted gross income (AGI) [IRC section 165(h)(2)]. The Disaster Tax Relief and Airport and Airway Extension Act of 2017 provided exceptions to these limitations in the case of federally declared disasters (FDD). In the event of an FDD, IRC section 139 excludes from gross income any amounts paid to or for the benefit of an individual to reimburse or pay reasonable personal, family, living, or funeral expenses incurred as a result of a qualified disaster.
New Rules under the TCJA
Under the TCJA, the only time an individual taxpayer can deduct personal casualty losses is as a result of an FDD. This limitation on deductibility will apply to any loss that will arise from tax years beginning after December 31, 2017, and before January 1, 2026.
The practical implication of the new rules is that taxpayers suffering casualty losses from events not declared a federal disaster, whether it be from flooding, fire, theft, or a local storm, will find no tax relief and thus be responsible for the entire cost of damages. This devastating financial outcome adds insult to the already substantial emotional and psychological injury such events can cause.
Unfortunately, floods and fires happen every day, even if most don’t receive news coverage. According to a report by the IRS (Individual Income Tax Returns Line Item Estimates, 2015, http://bit.ly/2qM6mHE), 72,323 taxpayers claimed casualty and theft deductions on their 2015 tax returns. These taxpayers are often lower-income individuals, and local businesses that form the backbone of their communities. While this author believes that Congress should correct this situation as soon as possible, in the meantime, CPAs armed with the knowledge of how the new rules work can help these individuals and businesses make alternate arrangements so that disaster does not turn into catastrophe.