Individual and business taxpayers may experience financial losses resulting from sudden damage or destruction to their property. Physical loss due to fire, windstorms, hurricanes, and flooding may immediately come to mind, but losses may also result from theft, vandalism, and even terrorist action. Losses sustained by nonbusiness taxpayers after 2017 are subject to new rules under the Tax Cuts and Jobs Act of 2017 (TCJA), discussed in further detail below. When evaluating the potential for new losses, current casualty loss insurance coverage may not be adequate.
Dealing with such losses requires the consideration of—
- tax rules, which have changed for individuals under the TCJA;
- insurance coverage and needs;
- government payments and reimbursements; and
- recovery from casualty events and disasters.
The Pre-2018 Casualty Loss Rules
Individuals usually could not deduct losses for damage or destruction of personal use property. There was, however, an exception that allowed for a deductible loss resulting from a casualty. A nonbusiness casualty event for individuals meant uninsured losses from fires, storms, shipwrecks, or other casualty. The meaning of “other casualty” has been developed by case law to mean a sudden, unexpected, or unusual event, including 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
- Volcanic eruptions.
Progressive deterioration, however, is not a casualty event for tax purposes because the destruction is gradual rather than sudden.
Determining the amount of the loss.
For nonbusiness (personal use) property, the loss was the lesser of the adjusted basis of the property (typically, cost) or the difference between the property’s value before and after the casualty event. Fair market value was to be determined by a “competent appraisal” [Treasury Regulations section 1.165-7(a)(2)(i)].
In lieu of obtaining an appraisal, the cost of repairs to the damaged property could be used as acceptable evidence of the loss in value if—
- the repairs were necessary to restore the property to its pre-casualty condition,
- the amount spent for repairs was not excessive,
- the repairs related only to the damage suffered in the casualty, and
- the value of the property after the repairs did not exceed its value immediately before the casualty [Treasury Regulations section 1.165-7(a)(2)(ii)].
The loss was reduced by any insurance and other reimbursements, and also by $100 per event [Internal Revenue Code (IRC) section 165(h)(1)]. If a taxpayer had insurance, a claim had to be made, even if submitting a claim would cause increased premiums or dropped coverage.
After determining the amount of the loss from a casualty, the total losses for the year were deductible as an itemized deduction to the extent they exceed 10% of adjusted gross income (AGI) [IRC section 165(h)(2)]. The casualty loss was an itemized deduction claimed on Schedule A of Form 1040, so itemizing was necessary in order to take a casualty loss deduction.
The TCJA Changes
Under changes made by the TCJA, nonbusiness taxpayers in tax years from 2018 through 2025 generally will no longer be able to claim Schedule A miscellaneous itemized deductions for casualty losses [IRC section 165(h)(5)(A)]. For casualty losses incurred in these years, only losses incurred in federally declared disaster areas will be deductible.
While casualty losses are generally not deductible for non-business taxpayers after 2017, such losses may interact with casualty gains and disaster losses in the following ways:
- Casualty losses (called nonfederal losses within this context) will reduce casualty gains for the tax year.
- If there is a net casualty gain, the amount of such gain reduces the amount of federally declared disaster losses for the year.
- The amount of disaster losses remaining is deductible, subject to the 10% of AGI floor.
Relief for 2016 and 2017 disasters.
Disaster losses that were incurred in 2016 and 2017 may be deductible if each such loss in the tax year exceeds $500 (rather than $100). The big tax break here is that the total of the year’s disaster losses does not have to exceed 10% of the individual’s AGI. Disaster losses qualifying under this provision may well present refund opportunities.
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 April 18, 2018 (the date of a tornado and severe storms in parts of North Carolina), and August 15, 2018 (NC-2018-02, May 9, 2018). Similarly, victims of severe storms and flooding that began on February 14, 2018, in parts of Indiana with filing deadlines between February 14, 2018, and June 29, 2018, have an extended due date of June 29, 2018 (IN-2018-01, May 7, 2018). 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 (three years for property used in a trade or business, or held for investment). 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.
Under changes made by the TCJA, nonbusiness taxpayers in tax years from 2018 through 2025 generally will no longer be able to claim Schedule A miscellaneous itemized deductions for casualty losses. For casualty losses incurred in these years, only losses incurred in federally declared disaster areas will be deductible.
Reviewing Insurance Coverage
When contemplating a casualty loss, two things may be true: such an event is unlikely to happen, but if it does, it can be financially devastating. Individuals and businesses should have the right type of coverage to protect their property. The following types of coverage are useful for both casualty events and federally declared disasters:
- Flood insurance. Coverage is obtained through the National Flood Insurance Program (https://www.floodsmart.gov/floodsmart/) 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. Coverage for hurricanes and sinkholes, however, is usually excluded unless separate policy riders are purchased. Flood coverage is also usually excluded, but may be available under a federally backed flood insurance program (see https://www.fema.gov/national-flood-insurance-program).
- 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 casualties are usually not covered and may not be coverable, including nuclear, biological, and chemical events. Acts of war are routinely excluded.
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.
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).
Individuals and businesses should have the right type of coverage to protect their property.
Furthermore, the IRS has a disaster loss workbook, Publication 584, that can help taxpayers compile a room-by-room list of belongings (http://bit.ly/2wGqoq0). The IRS also has more information about disaster assistance and emergency relief for individuals and businesses (http://bit.ly/2f2rkwL).
Checklist for Recovering from a Casualty or Disaster
- ☐ Have I reviewed my existing insurance coverage for possible casualties or disasters?
- ☐ Do I have a plan for my family’s communication, in case of a casualty or disaster?
- ☐ Do I have a casualty or disaster preparedness plan for my business?
- ☐ Do I have a list on hand of important contact information following a casualty or disaster (insurance agent, FEMA, SBA)?
- ☐ Do I fully understand the need for records and appraisals following a casualty or 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?
This article, which originally appeared in the December 2016 CPA Journal, has been updated by the authors reflect the impact of the Tax Cuts and Jobs Act.