By Steven Schlachter, CPA, MBA
Personal casualty losses. It has been almost 12 weeks since Hurricane Sandy unleashed its wrath along the East Coast. Many that suffered damage from the storm have not been made whole by FEMA and few have received full settlements from their insurance companies. Some measure of conciliation is available from Uncle Sam for those that suffered damage. This comes in the form of a tax write-off known as a Casualty Loss Deduction.
The Casualty Loss Deduction is not new in the tax law. It has been around for decades. This article is the first in a three-part series that will explore the tax rules and how to plan for the deduction. The rules differ depending if the loss is personal or business-related. This article addresses personal casualty losses.
In general, taxpayers can claim a deduction for personal monetary losses sustained as a result of a casualty or disaster. This deduction is meant to reduce the taxpayer’s tax burden and thereby provide monetary relief through tax savings. Normally, the Casualty Loss Deduction is claimed in the year the loss is sustained. However, when a casualty loss is sustained in a designated disaster area (such as the area affected by Hurricane Sandy), the loss may be claimed in the year of the loss (2012) or the immediately preceding year (2011).
Personal losses are defined as losses sustained from fires, thefts, storms, car accidents, and similar “sudden, unexpected, or unusual” events. Hurricane Sandy meets this definition.
How do I calculate my loss deduction? The loss is measured as the lesser of (a) the reduction in property value as a result of the event, and (b) the tax basis in the property (usually the purchase price of the property plus the cost of improvements). For example, assume a work of art was purchased for $5,000 in 2002 and had appreciated in value to $30,000 right before the storm. After the storm damaged the artwork, its appraised value was reduced to $10,000. The allowed loss would be $5,000 (original purchase price) and not $20,000 (the drop in value).
It may be difficult to document these figures. The burden of proof regarding the loss claimed is on the taxpayer. Original receipts help establish cost. In some cases, appraisals will be needed to establish pre- and post-loss values. For real estate, such as a personal residence, determining the loss can be a daunting task, particularly when the property has undergone improvements. Alternative methods for proving the tax loss will be discussed in a subsequent article.
What are the limitations on the deduction? The loss is subject to three limitations. In many cases, these limitations result in no deduction being available. First, to the extent the damaged property is insured, the loss must be reduced by actual or reasonably expected insurance reimbursement. Failure to file an insurance claim in the hope of increasing the deduction will not work. The IRS can reduce the loss by the insurance reimbursement that could have been received.
A further limitation is that each casualty must be reduced by $100. This reduction is per “event,” not per item damaged. Thus, if a storm knocks over a tree that damages a car and home, there are three property losses (tree, car, and house) and only one reduction of $100.
The third limitation requires combining all casualty losses (under the above guidelines), and reducing the total by 10% of adjusted gross income (AGI). Only the loss amount above this “floor” can be claimed as a deduction. It is this final limitation that often wipes out the deduction. For example, if AGI is $75,000, casualty losses are only deductible to the extent they exceed $7,500 (10% of $75,000).
Unfortunately for many, the Hurricane Sandy losses may exceed these limitations. There is discussion in Congress to have the final two limitations discussed earlier waived for Hurricane Sandy victims, as was the case for some of the previous storms in other parts of the country. This may, in fact, be part of an overall Hurricane Sandy relief bill. Stay tuned.
Can non-itemizers take the casualty loss deduction? Individual taxpayers who don’t itemize their deductions on their income tax return can’t deduct casualty losses for personal-use property. However, in the past, this limitation has been waived. Such a waiver is currently under discussion on Capitol Hill.
Casualty gains. On certain occasions, a casualty may ultimately result in gain, rather than a loss for tax purposes. For instance, a house is purchased for $300,000 and increases in value to $600,000 right before it is destroyed. Its owner receives $600,000 in insurance proceeds; he or she will have a gain of $300,000. In many cases, the tax liability on a casualty gain can be avoided or deferred if a replacement property is purchased within a prescribed period. v
(To be continued)
Steven Schlachter is a senior tax manager at the accounting, tax, and business advisory firm of Margolin, Winer & Evens LLP.