Homeowners and businesses across the country have experienced weather-related disasters in recent months. From hurricanes, tornadoes and other severe storms to the wildfires again raging in the West, natural disasters have led to significant losses for a wide swath of taxpayers. If you are among them, you may qualify for a federal income tax deduction, as well as other relief from the IRS.
Eligibility for the Casualty Loss Deduction
Casualty losses can result from the damage, destruction or loss of property due to any sudden, unexpected or unusual event. Examples include floods, hurricanes, tornadoes, fires, earthquakes and volcanic eruptions. Normal wear and tear or progressive deterioration of property does not constitute a deductible casualty loss. For example, drought generally does not qualify.
The availability of the tax deduction for casualty losses varies depending on whether the losses relate to personal-use or business-use items. Generally, you can deduct casualty losses related to your home, household items and personal vehicles if they are caused by a federally declared disaster — meaning a disaster that occurred in an area that the U.S. president declares eligible for federal assistance. Casualty losses related to business or income-producing property (for example, rental property) can be deducted regardless of whether they occur in a federally declared disaster area.
Casualty losses are deductible in the year of the loss, usually the year of the casualty event. If your loss stemmed from a federally declared disaster, you can opt to treat it as having occurred in the previous year. You may receive your refund more quickly if you amend the previous year's return than if you wait until you file your return for the casualty year.
The Role of Reimbursements
If your casualty loss is covered by insurance, you must reduce the loss by the amount of any reimbursement or expected reimbursement (you also must reduce the loss by any salvage value). Reimbursement also could lead to capital gains tax liability.
When the amount you receive from insurance or other reimbursements (less any expense you incurred to obtain reimbursement, such as the cost of an appraisal) exceeds the cost or adjusted basis of the property, you have a capital gain. You will need to include that gain as income unless you are eligible to postpone reporting the gain.
You may be able to postpone the reporting obligation if you purchase property that is similar in service or use to the destroyed property within the specified replacement period. You also can postpone if you buy a controlling interest (at least 80%) in a corporation owning similar property or if you spend the reimbursement to restore the property.
Alternatively, you can offset casualty gains with casualty losses not attributable to a federally declared disaster. This is the only way you can deduct personal-use property casualty losses incurred in areas not declared disaster areas.
The Loss Amount Versus the Deduction
For personal-use property, or business-use or income-producing property that is not completely destroyed, your casualty loss is the lesser of:
- The adjusted basis of the property immediately before the loss (generally, your original cost, plus improvements and less depreciation); or
- The drop in fair market value (FMV) of the property as a result of the casualty (that is, the difference between the FMV immediately before and immediately after the casualty).
For business-use or income-producing property that is completely destroyed, the amount of the loss is the adjusted basis less any salvage value and reimbursements.
If a single casualty involves more than one piece of property, you must figure the loss on each separately. You then combine these losses to determine the casualty loss.
An exception applies to personal-use real property, such as a home. The entire property (including improvements such as landscaping) is treated as one item. The loss is the smaller of the decline in FMV of the entire property and the entire property's adjusted basis.
Other limits may apply to the amount of the loss you may deduct, too. For personal-use property, you must reduce each casualty loss by $100 (after you subtract any salvage value and reimbursement).
But that is not all. For personal-use property, you also must reduce your total casualty losses by 10% of your adjusted gross income, after you have applied the $100 rule. As a result, smaller personal-use casualty losses often provide little or no tax benefit.
The Requisite Records
Documentation is critical to claim a casualty loss deduction. You will need to be able to show:
- That you were the owner of the property or, if you leased it, that you were contractually liable to the owner for the damage;
- The type of casualty and when it occurred;
- That the loss was a direct result of the casualty; and
- Whether a claim for reimbursement with a reasonable expectation of recovery exists.
You also must be able to establish your adjusted basis, reimbursements and, for personal-use property, pre-and post-casualty FMVs.
The IRS has granted tax relief this year to victims of numerous natural disasters, including "affected taxpayers" in Alabama, California, Kentucky, Louisiana, Michigan, Mississippi, New Jersey, New York, Oklahoma, Pennsylvania, Tennessee and Texas. The relief typically extends filing and other deadlines. (For detailed information for your state visit: https://bit.ly/3nzF2ui.)
A Team Effort
If you have incurred casualty losses this year, tax relief could mitigate some of the financial pain. We can help you maximize your tax benefits and ensure compliance with any extensions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.