Losses from natural disasters are generally tax deductible, but taking the deduction requires properly valuing the amount of the loss. The IRS recently provided new guidance that gives taxpayers seven safe harbor methods for making this often difficult calculation. The authors illustrate how to use each of the new safe harbor provisions, and note how the deduction has been impacted by the Tax Cuts and Jobs Act.
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The numerous high-profile natural disasters of recent years have cost people their homes and personal property. Claiming any resulting tax losses requires properly valuing those losses—a task that leaves many bewildered. On December 13, 2017, the IRS issued Revenue Procedure 2018-08, giving taxpayers seven new safe harbor methods for determining the amount of their personal casualty/theft loss. Five of the methods in the revenue procedure (effective immediately) apply to the valuation of loss from the taxpayer’s personal-use residence, and the other two apply to the loss valuation of personal belongings. All seven provide tax relief for taxpayers who suffered casualty losses in 2017 as a result of Hurricanes Harvey, Irma, and Maria, as well as any taxpayers who might suffer losses in the 2018 hurricane season. This article explains these seven methods, providing examples to help taxpayers and their advisors navigate this challenging and often-litigated area of the tax law.
Current Law and Regulations on Casualty Losses
Personal casualty losses are deductible as itemized deductions under Internal Revenue Code (IRC) section 165(a) and (c), which allows a deduction for any personal loss that arises from fire, storm, shipwreck, other casualty, or theft, not compensated for by insurance or otherwise compensated. It is important to note that the Tax Cuts and Jobs Act of 2017 (TCJA) limits the deduction for personal casualty losses to those attributable to federally declared disasters, effective for losses incurred in taxable years beginning after December 31, 2017, through December 31, 2025. (See http://www.fema.gov/disasters to identify federally declared disasters.)
The TCJA does not change the two limitations imposed by IRC section 165(h). The first limitation is a $100 floor per casualty event, meaning that only the loss amount in excess of $100 is deductible. The second limitation is a 10%-of-adjusted-gross-income (AGI) floor, which applies to the total of the taxpayer’s net casualty losses for the year after subtracting insurance reimbursements and the $100 dollar per event limitation. It should be noted, however, that the Disaster Tax Relief and Airport and Airway Extension Act of 2017 created special provisions for the Hurricanes Harvey, Irma, and Maria disasters. Specifically, it waives the 10%-of-AGI floor and raises the $100 threshold to $500. It also allows the casualty loss to be added to the standard deduction if the taxpayer does not itemize deductions. The TCJA has expanded these special provisions to include all 2016 and 2017 disasters. Tax advisors should be alert to potential modification of the rules of IRC section 165 following future disasters.
IRC section 165(i)(1) further permits individuals who suffer a federally declared disaster area loss to elect to take the loss in the taxable year immediately preceding the taxable year in which the disaster occurred. For example, Hurricane Harvey victims may take their loss when they file their 2017 returns or by filing amended returns for 2016. The purpose of this provision is to expedite the tax savings from the loss deduction.
Treasury Regulations section 1.165-7(b) explains that the amount deductible is the lesser of—
- the fair market value of the property immediately before the casualty less the fair market value of the property immediately after the casualty, or
- the adjusted cost basis of the property.
Treasury Regulations section 1.165.7(a)(2) states that the “before” and “after” fair market values are generally determined by competent appraisal. However, it also states that the cost of repairs to the damaged property is acceptable as evidence of the loss of value if the individual can show that the repairs are necessary to restore the property to its condition before the casualty, are not excessive, and do not address more than the damage suffered, as well as that the value of the property after the repairs does not exceed the value of the property before the casualty.
Revenue Procedure 2018-08 attempts to ease the burden imposed on taxpayers who must determine their casualty loss deduction and wish to avoid time-consuming IRS audits and possible litigation. The seven methods provide safe harbors that individuals can use to determine decreases in fair market value. The IRS will not challenge these safe harbor methods if they are properly applied.
Personal-use residence and belongings defined.
To qualify for the safe harbors, a personal-use residence is defined as real property, including improvements, that is owned by the individual who suffered the casualty loss and contains at least one personal residence. Importantly, it does not include a personal residence if any part of it is used as rental property or contains a home office used in a trade or business or other profit-seeking activity. Furthermore, it must be a single-family residence or residential unit; this does not include a condominium or cooperative unit where the individual does not own the structural components of the building or owns only a fractional interest. It also does not include a mobile home or trailer. Finally, if an individual owns two or more personal-use residences, he may use the same or different safe harbors for each residence.
A personal belonging is defined as an item of tangible personal property owned by the individual and not used in a trade or business or other profit-seeking activity. This does not include a boat, aircraft, mobile home, trailer, or vehicle, nor an antique or other asset that maintains or increases its value over time.
Personal-Use Residence Safe Harbors
Estimated repair cost method.
To determine the decrease in the fair market value of a residence under this safe harbor, an individual may use “the lesser of two repair estimates prepared by two separate and independent contractors, licensed or registered in accordance with state or local regulations.” The two estimates must itemize the costs to restore the individual’s personal-use residence to its condition immediately before the casualty. The costs of any improvements or additions that increase the value of the property beyond its pre-casualty value must be excluded from the estimates. This method is only available for casualty losses of $20,000 or less, calculated prior to the IRC section 165(h) limitations (i.e., $100 and 10%-of-AGI floor).
Example. Alex suffers a loss to his main home, on which he carries no insurance, as a result of a hurricane and associated flooding. He obtains two qualified and itemized estimates. Contractor 1 estimates the repair to be $18,000. Contractor 2 estimates the repair to be $28,000, but includes $9,000 to elevate the home to meet new construction requirements. The $9,000 cost must be excluded from the second estimate, as it is considered an improvement that increases the value of the property. Alex would use $18,000 (the lesser of the two estimates) under this safe harbor as the decrease in the fair market value of his home as a result of the hurricane casualty. Note that the $18,000 loss is under the $20,000 cap for the use of this safe harbor.
The cost of any improvements or additions that increase the value of the property beyond its pre-casualty value must be excluded from the estimate.
De minimis method.
Under this method, “an individual may estimate the cost of repairs required to restore the individual’s personal-use residential real property to the condition existing immediately prior to the casualty.” Like the first safe harbor, the cost of any improvements or additions that increase the value of the property beyond its pre-casualty value must be excluded from the estimate. The estimate must be a good-faith estimate, and records must be kept detailing the methodology used to determine the loss. This method is only available for casualty losses of $5,000 or less, calculated prior to the IRC section 165(h) limitations.
Example. Blake suffers a casualty loss to the roof of her principal residence as a result of hail damage. She estimates that the cost to repair the roof to its pre-casualty condition is $3,900. Her insurance deductible exceeds $3,900; thus, Blake would be able to use the de minimis method to establish a loss of $3,900, which is under the $5,000 ceiling required for this safe harbor.
Under this method, an individual may use the estimated loss detailed in his homeowner’s or flood insurance company’s report setting forth the estimated loss sustained as a result of damage to the individual’s personal-use residence. This method may be used for any casualty loss and, unlike the previous two methods, does not have a dollar limit for its use.
Example. Chris’s home suffers severe flood damage as a result of torrential rainfall. He is covered by flood insurance; his coverage limit is $250,000, and the insurance report details a loss of $360,000. Chris may use the $360,000 loss per the report under this safe harbor for a casualty loss after insurance of $110,000 (i.e., the loss minus the coverage limit).
Under this method, “an individual may use the contract price for repairs specified in a contract prepared by an independent contractor, licensed or registered in accordance with state or local regulations, setting forth the itemized costs to restore the individual’s personal-use residential real property to the condition immediately prior to the federally declared disaster.” To use this method, a binding contract must be signed by the contractor and the individual. Like the previous safe harbors, the costs of any improvements or additions that increase the value of the property beyond its pre-disaster value must be excluded from the contract price. This method does not have a dollar limit for its use.
Example. Dana’s home suffers fire damage. The area in which her home is located is a federally declared disaster area. Dana signs a contract with a licensed independent contractor to fix the damage to her home; the itemized cost totals $300,000 and excludes any improvements or additions beyond restoring the home to its pre-fire condition. Her insurance coverage amount is $200,000. Dana may use the $300,000 binding contract cost under this safe harbor for a net loss after insurance of $100,000.
Disaster loan appraisal method.
Under this method, an individual may use “an appraisal prepared for the purpose of obtaining a loan of federal funds or loan guarantee from the federal government setting forth the estimated loss the individual sustained as a result of damage to or destruction of the individual’s personal-use residential real property from a federally declared disaster.” This method does not have a dollar limit for its use.
Example. Evan’s home suffers damage as a result of a tornado. The area in which his home is located is a federally declared disaster area. Evan does not have insurance coverage for the damage, so he applies for a disaster loan through the U.S. Small Business Administration (SBA). An SBA verifier appraises the estimated loss at $120,000. He may use this amount for his casualty loss under the disaster loan appraisal safe harbor method.
Personal Belongings Safe Harbors
In addition to the five safe harbors for an individual’s personal residence, Revenue Procedure 2018-08 specifies two additional safe harbor methods for an individual’s personal belongings.
De minimis method.
Under this method, an individual makes a good faith estimate of the decrease in fair market value of her personal belongings. This method is available for any casualty or theft loss of $5,000 or less, prior to the IRC section 165(h) limitations. In order to use this method, an individual must have records describing the affected personal belongings and detailing the methodology used for estimating the loss.
Example. Frances lost personal belongings in a windstorm. Using thrift shop values, she estimates the value of the items at $7,500. Her contents insurance policy accepts these values and, after applying a $3,000 deductible, reimburses her $4,500. Frances may use $3,000 as her casualty loss relative to her personal belongings under the de minimis method because the amount is $5,000 or less.
Replacement cost method.
To use this method, an individual must first determine the current cost to replace a personal belonging with a new one and then determine the pre-disaster market value of the item by reducing the replacement cost by 10% for each year that the individual owned the item. If the item was owned by the individual for nine or more years, the pre-disaster market value is 10% of the current replacement cost.
The fair market value of the item after the disaster is then subtracted from the value before the disaster. If the personal belonging is destroyed or stolen as a result of the disaster, its after-disaster value is deemed to be zero.
The final step in the calculation is to compare the decrease in fair market value with the cost basis of the item, taking the lesser of the two as the casualty loss before any insurance recovery. Any insurance reimbursement received or expected must be subtracted from this amount.
Example. Gerry’s personal belongings include a bed destroyed by a hurricane in a federally declared disaster area. He purchased the bed for $900 six years prior to the hurricane. The cost to replace the bed with a similar new one is $1,200. Gerry receives $200 under his insurance coverage. His loss deduction relative to the bed before IRC section 165(h) limitations would be calculated as follows:
- Fair market value before the disaster $1,200 × 40% = $480
- Fair market value after the disaster = $0
- Decrease in fair market value = $480 − $0 = $480
- Cost basis = $900
- Lesser of cost basis or decrease in fair market value = $480
- Less insurance reimbursement = $200
- Net casualty loss deduction = $280
An individual may not use this safe harbor method for the following personal belongings: boats, aircraft, mobile homes, trailers, vehicles, or an antique or other asset that maintains or increases its value over time. Vehicles include automobiles, motorcycles, motor homes, recreational vehicles, sports utility vehicles, off-road vehicles, vans, and trucks. Pre-disaster values for these items are instead determined by consulting established pricing sources, such as “blue book” values for automobiles.
An individual who uses any of the safe harbor methods in this revenue procedure must reduce the loss by the value of any no-cost repairs.
Reduction for No-Cost Repairs
The last section of the revenue procedure notes that under IRC section 165(a), a casualty loss must be reduced by insurance or other amounts received. This includes the value of repairs provided by another party at no cost to the individual. No-cost repairs include the repair or rebuilding of an individual’s personal residence by volunteers or repairs made for a token cost, donation, or gratuity.
An individual who uses any of the safe harbor methods in this revenue procedure must reduce the loss by the value of any no-cost repairs.
Example. Hayden suffers damage to her home as a result of a hurricane. She is covered by insurance for the loss. The insurance report details the loss at $300,000; her coverage limit is $250,000. Volunteers from a local church provide help in repairing the damage, which help she values at $15,000. Under the insurance method safe harbor, Hayden may use the $300,000 loss per the report for a casualty loss after insurance of $50,000; however, she must also subtract the $15,000 value of the no-cost repairs provided by the church volunteers, resulting in a net casualty loss of $35,000.
Welcome Relief to Those Who Need It
Revenue Procedure 2018-08 gives taxpayers much-needed help in valuing their casualty losses by providing seven new safe harbors for calculating the deductible amount of the loss. While not the topic of this article, it should be noted that the IRS has also issued Revenue Procedure 2018-09, which provides the cost indexes safe harbor method, which individuals may use in determining the amount of their casualty losses for their personal-use residences damaged or destroyed as a result of the Hurricanes Harvey, Irma, and Maria. While it has no applicability beyond these hurricanes, this additional safe harbor method, along with the seven methods discussed above, will do much to assist taxpayers in calculating their casualty loss deductions now and in the future. Taxpayers and their advisors should, however, still carefully document their disaster losses as well as the methodology employed to compute their deductions.