Casualty Loss Deductions for Tax Purposes
Written by
Guido van der
Hoeven, Extension Specialist/Lecturer and Arnold W. Oltmans, Associate
Professor in Agricultural and Resource Economics, North Carolina State
University.
The tremendous property damage caused by hurricane
Isabel, to homeowners and businesses has spawned numerous tax-related
questions. Property owners, looking for
some economic relief to their situation, are asking what they can or
should do
to properly claim an income tax deduction for their losses. The
following is a general summary of the
income tax rules and regulations regarding casualty loss
deductions. It is a useful starting point for clarifying
tax-related questions that are commonly asked.
Because individual circumstances vary, however, taxpayers are
encouraged
to seek additional advice from their professional tax preparer and
other
detailed IRS publications.
Business
or Nonbusiness
Property:
The first distinction that must be made is whether the
damaged property was owned for business or nonbusiness (i.e. personal
use)
purposes. The limits on the amount of
the tax deduction allowed and the methods of reporting are different. Also, timber held for investment has some
unique tax-related characteristics.
Nonbusiness
Property
For nonbusiness property--such as a house used as a
personal residence, trees on a residential lot, personal property, car,
etc.
--- the amount of casualty loss is the smaller of the decrease
in the
fair market value (FMV) of the property caused by the casualty, or
the adjusted
basis (i.e. remaining cost) of the property. In
other words, a taxpayer cannot deduct more than their cost
invested in the property. This amount
is then reduced by an insurance claim payment or other reimbursement
received. The costs of cleaning up
after the property, repairing or replacing the property, temporary
housing,
rental car expenses, or other incidental expenses are not part
of the
casualty loss.
Determining the loss in fair market value of the property
is the hard part. FMV before and after
the casualty must be proven and documented.
This is commonly done through a property appraisal by a
competent,
experienced professional. Photographs
taken before and after the casualty along with other property records
are
useful in this process. Establishing
the FMV loss of trees is more difficult than for houses, cars, and
personal
property. However, there are
well-established guidelines for doing so used by arborists,
professional
foresters, tree and landscape appraisers.
Landscape and forestry specialists in the Cooperative Extension
Service
can direct homeowners to publications related to tree valuation and
appraisal.
Although certain costs mentioned previously are not part
of the casualty loss itself, they can be used as a measure of the loss
in FMV
in lieu of an appraisal. The cost of
cleaning up, making repairs, and restoring property or the landscape as
near as
possible to its condition prior to the casualty may be used as a
measure of the
decrease in FMV. If the repairs are not excessive, are for the damage
only, and
do not increase the FMV beyond its value prior to the casualty, these
expenses
may be used as a measurement of FMV loss.
Thus, it is important for property owners to document the
loss in fair market value as soon as possible, to know their cost basis
in
property, and to record insurance payments as well as expenses related
to the
casualty.
Limit on
Deductions
The amount of casualty loss after insurance
reimbursements are figured in is not the amount of deductible
loss for
tax purposes. The loss after insurance
reimbursement must be reduced by $100 and 10% of the taxpayers adjusted
gross
income. In other words, the first $100
cannot be deducted, ($100 rule) and only the amount of loss that
exceeds 10% of
a taxpayers adjusted gross income is deductible (10% rule). Adjusted gross income is the amount reported
on line 33 of the taxpayer's 1040 form.
Furthermore, casualty losses above the $100 rule and 10%
rule must be calculated using Form 4684 and listed as an itemized
deduction on
Schedule A of the taxpayer's return.
For taxpayers who do not normally itemize their deductions, this
may
have the effect of further reducing the effective deduction they may be
entitled to from a casualty loss.
The bottom line, in practical terms, is that numerous
homeowners who suffered an economic loss of property not fully covered
by
insurance will not have a deductible loss for tax purposes. The 10% rule and requirement to itemize
wipes out their tax deduction. It is
also possible, in the case of two taxpayers who have nearly identical
amounts
of casualty loss, that one will have a tax deduction and the other will
not
because their incomes are different. Renters, who often don't itemize,
are at
an additional disadvantage.
Federal
Disaster Area
Designation
Does living in a declared federal disaster area change
the rules? Not much. The
only difference this makes to a taxpayer
for casualty loss purposes is that the taxpayer is allowed to take the
loss, if
any, in the prior tax year. In other
words, instead of waiting until 2003 tax returns are filed (in 2004) to
deduct
a 2003 casualty loss, the taxpayer can choose to amend the 2002 return
if they
wish and file for whatever refund would result from having an
additional tax
deduction. The other rules for
calculating the loss, the $100 rule, and 10% rule remain the same.
The other effect is for a taxpayer who actually has a
gain from the casualty (strange as that may sound), the two-year period
for
replacing property in order to postpone taxation of the gain is
extended to
four years for the replacement of the principal residence.
For individuals living in an area declared a disaster by
the President, the IRS will abate interest on income tax for the length
of any
extension granted for filing income tax returns and paying income tax. For other taxpayers (corporations for
example) the same abatement rules apply if these taxpayers are in a
federally
declared disaster area.
Business
Property
If the casualty causes damage to property held for
business purposes, i.e., for producing income, the casualty loss is
calculated
in the same way with one important exception.
There is no deduction limit, no $100 or 10% rules, and the loss
is not
reported as an itemized deduction. The
entire casualty loss, after insurance reimbursement, is deductible. In addition, incidental expenses for
cleanup, temporary rentals, and minor repairs may be deducted as
ordinary
business expenses. Major repairs and
replacement costs may have to be capitalized, however, and deducted as
depreciation over time. If the loss
occurs in a federal disaster area, the same rules for deducting the
loss early
and postponing any gain apply.
Therefore, the owner of business property must also determine
the loss in fair market value and the cost basis of the property. Losses of property that has no cost basis,
such as growing crops and raised livestock are not deductible; the
ordinary
expenses in raising them are deducted.
Purchased products and products held in inventory that are lost
due to a
casualty may or may not be deductible depending on whether the cash or
accrual
method of reporting taxes is used.
Example
Hurricane Isabel caused damage to a taxpayer's property
that reduced its FMV by $25,000. The
adjusted cost basis of the property is $85,000, and the insurance
company
reimbursed the owner $20,000 for the loss.
Since the loss in FMV is less than the adjusted basis, the
$20,000
insurance payment is subtracted from $25,000 for a tentative casualty
loss of
$5,000. If the property was used in a
business, the entire $5,000 is deductible.
If the property is nonbusiness property, the $5,000 is
reduced further by the $100 rule to $4,900.
If the taxpayer has $49,000 or more adjusted gross income (AGI),
the net
casualty loss is zero since 10% of $49,000 equals $4,900.
If the taxpayer has less than $49,000 AGI,
the casualty loss is $4,900 minus 10% of AGI.
This amount would be listed as an itemized deduction on Schedule
A of
the tax return. Total itemized
deductions would have to be greater than the taxpayer's standard
deduction to
realize any benefit from the casualty loss.
The taxpayer could wait to take the deduction on his
upcoming 2003 tax return or, if located in a federal disaster area,
amend the
2002 tax return, apply the deduction there, and seek a tax refund now.
Timber
The loss of standing timber from the hurricanes resulted
in major economic losses to owners of timberland. However,
this economic loss does not result in a casualty tax
loss of equal amount for most taxpayers.
Indeed, for many, there is little if any deductible loss. In many instances, where the downed timber
is salvaged and sold, there is actually a taxable gain rather than a
taxable
loss. That is certainly not the news
that most timber owners are anticipating.
The most important piece of information that must be
documented in determining the gain or loss on timber is the adjusted
basis in
the timber. This is, in a broad sense;
the amount of money invested in the timber itself but not the amount in
the
land on which the timber stands. On
timber that has been previously cut by the current owner, the basis
would be
the cash outlay incurred in previous years to reforest cutover woodland
or to
plant bare land to trees. If the
landowner allowed the land to reforest naturally with no cash outlay,
the
timber stand has no basis. If the
landowner has no record of cash outlays, there is no documented basis. Since a casualty loss cannot exceed the
basis in the timber, owners with no basis or a low basis have little or
no
casualty loss to deduct.
When a tract of land has been purchased after it was last
cut and reforested, the timber basis is the portion of the purchase
price
allocated to the timber apart from the land, buildings, fences, wells,
and
other items of value. Timberland
acquired by inheritance has a basis equal to the fair market value of
the
timber as appraised at the time of the deceased's estate settlement. The basis of property received by gift is
generally the same as the basis of the person who gave the gift.
In situations where a landowner acquired a parcel of land
at some past time and never documented a basis, an estimate of the
volume and
value of the timber at the time of acquisition (purchase, inheritance,
or
purchase by the donor of a gift) must be made.
The procedure for arriving at this estimate is called a back
cruise. However, back cruising is
permissible in
determining basis only if done while trees are standing.
Once trees are cut, tax laws prohibit back
cruising.
If a casualty completely destroys a timber stand with no
opportunity for salvage, the amount of basis minus insurance recovery
is the
maximum casualty loss that can be claimed.
If the insurance recovery exceeds the basis, the taxpayer has a
taxable
gain instead of a loss.
Timber that is damaged but not completely destroyed may
often be salvaged. If salvage is not
possible, the taxpayer is allowed a partial casualty loss.
The owner must determine what percentage of
the timber stand has been lost (depleted) and then must multiply that
percentage times the timber basis.
Insurance reimbursement is applied against this depletion
amount,
resulting in the final amount of casualty loss or taxable gain. In the
case of
timber being salvaged after the casualty, the amount received from
salvaged
timber is treated as a sale, along with insurance proceeds. The total sales amount minus any costs of
selling minus part of the basis (the depletion amount) gives the amount
of gain
or loss. Timber salvaged often results
in a taxable gain rather than a casualty loss, not the result a
taxpayer is
anticipating.
Because gains and losses depend on the amount of timber
basis individual taxpayers have, the same damage done to adjacent
tracts of
timber may produce a large casualty loss for one owner, a small loss
for
another, no loss for another, and a gain for yet another timber owner.
Tax
Deferral of Gain
A
casualty may result in a gain rather than loss. For
business property, this is most often
the case when the insurance proceeds exceed the remaining basis of the
property
lost. For timber, this is most often
the case when timber is salvaged after the casualty.
With nonbusiness property, gain is less likely, though not
impossible, to occur from a casualty.
If a net gain does result in either of the cases, income taxes
on the gain
can be deferred if the gain is reinvested in certain "like-kind"
property. The taxpayer has a two year
time period to make the like-kind replacement.
Reduction
of Basis
When a casualty loss is deducted, the taxpayer must
reduce the basis in the property by the same amount.
In a total loss of property, this is a moot point, but in a
partial loss where the property still exists, this becomes part of the
property
records a taxpayer must keep.
Summary
Economic relief from losses due to hurricane Isabel
through the Internal Revenue Service may not be as easy to get as
taxpayers
would like to believe. Or, as they may
be led to believe by incomplete information coming from taxpayer
word-of-mouth,
some tax preparers, and even pronouncements of some public officials. While some taxpayers suffering losses may
indeed be able to claim a casualty loss and amend last year's tax
return to
claim a tax refund, most will find little if any tax relief in a
process that
is not simple to complete. Property
owners who think they may have a loss beyond the amount they were paid
from
insurance reimbursement should study the casualty loss rules carefully. They should also seek further advice,
especially in determining the reduction in fair market value and in
interpreting the cost basis of their property.
Information
Further information on casualty losses can be found in
IRS Publication 17, "Tax Guide for Individuals, 1998", IRS
Publication 547, "Casualties, Disasters and Thefts, 2002”,
IRS Publication 334, "Tax Guide for
Small Businesses, 2002", and IRS Publication 225, "Farmers Tax Guide,
2002". These may be obtained by
calling 1-800-829-1040 or 919-733-4684.
Information on timber may be found in a publication of the North
Carolina Cooperative Extension Service, publication AG-296, "Federal
Income Taxes for North Carolina Timber Growers. Professional
tax preparers may
have additional information.
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