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The Tax Implications of Casualty-loss Deductions

Kevin Hines

Kevin Hines

The significant tornado-related damage caused to homeowners and business owners across Western Mass. has generated numerous tax-related questions. Property owners are asking if there is any economic relief by way of income-tax deductions for the casualty losses that they have incurred.
What follows is a general discussion of the income-tax rules regarding casualty-loss deductions and possible taxable gains. A review of these rules is a useful launching point for you to review your own situation with your tax professional, since each situation will be unique.
For starters, there are different rules for deducting damage losses depending on whether the loss is incurred on business property or non-business (personal-use) property.

Business Property
If the damage was caused to business property (i.e. income-producing property), the loss is the smaller of the decrease in fair market value (FMV) caused by the casualty and the adjusted tax basis (investment less depreciation deducted over time). The lower of the two numbers then must be reduced by insurance reimbursements.
This calculated value represents the casualty loss. Other expenses such as clean-up costs and temporary replacement costs are not part of the casualty loss. You may be able to consider these costs as other deductible business expenses, but they are not part of the deduction for the loss.
In order to establish the amount of the loss, you may need to contact an appraiser (real estate, machinery/equipment appraiser, or other qualified person) to determine the value both before and after the casualty loss in order to determine the decrease in FMV. Documentation (pictures, reports, replacement costs) should be kept at least three years beyond the sale of the property to establish the loss and prove the adjusted tax basis of the investment.
All casualty gains and losses are to be netted in any calendar year.

Non-business Property
Personal property losses follow similar loss rules as business property to determine the amount of the loss. However, there are two additional hurdles to jump through in order to take the loss deduction. The loss must exceed $100 and 10% of the taxpayer’s adjusted gross income. By completing federal form 4684, you can determine the amount of the deduction, which then becomes one of your itemized deductions in the year of the loss.
The bottom line is that many taxpayers who suffered a loss may not have a tax deduction since the loss must exceed the reimbursement of insurance proceeds, the $100 threshold, and 10% of the taxpayer’s adjusted gross income.

Tax Deferral of Gain
A casualty event may result in a gain rather than a loss. For business property, this often happens when insurance proceeds exceed the adjusted basis of the property lost. If a net gain does occur, the taxpayer generally has two years to replace the property with like-kind property of equal value in order to defer the gain.
For example, if the casualty loss was rental property, it must be replaced with similar property, but it does not have to be at the same location, just the same use of the property (income-producing property). The replacement property cannot be a vacation home, since it is not of similar character.
With non-business property, gain is less likely. However, if someone has owned their residence for a long period, it is possible there will be a gain. Again, you generally have two years to replace the property with like-kind property. However, there is another opportunity if the home is considered your principal residence. Each individual can exclude gain on the sale of a principal residence of $250,000 ($500,000 for a married couple) if they had used the home as the primary residence for 24 out of the last 60 months and the ownership of the property is relinquished.
Once this principal residence exclusion is used, it usually will reset so that, 24 months down the road, you will again have an additional exclusion available to you. This may provide a unique planning opportunity for some individuals to exclude a portion of the gain rather than defer the gain.

Reduction in Basis
When a casualty loss is deducted, the taxpayer is required to reduce the basis in the property by the amount of the loss deduction. This will prevent a double deduction when the property is sold later.

Federal Disaster Area Designation
For Hampden and Worcester counties, the June 1 tornadoes were declared a federal disaster event by the president. There are a few additional rules affecting taxpayers in these two counties.
First, there will be an extension of time to pay certain taxes and file certain returns to give taxpayers some time to recover and prepare returns. Any returns or tax payments due from June 1 through Aug. 8 were given an extension to file until Aug. 8. There was also a waiver of penalties and interest. Second, the replacement period is extended from two years to four years when replacing property or reinvesting within the disaster area. Third, taxpayers are allowed to choose between the prior year (2010 tax year) and the current year to take the casualty-loss deduction. This may be advantageous for two reasons: to speed up a tax refund and allow a taxpayer to maximize the tax benefit of the loss deductions.

Additional Information
Additional information can be obtained by consulting the Internal Revenue Service Publication 547 at www.irs.gov/publications/p547, instructions for Federal Form 4684, Casualty and Theft Losses, or by contacting your tax preparer. It is wise to consult with your preparer well in advance of the tax-filing deadline so that you may take full advantage of any elections and planning opportunities.

Kevin E. Hines, CPA, MST, CVA, CSEP, is a partner with Meyers Brothers Kalicka, P.C., with specialties in business valuations, estate planning, and taxes;  (413) 536-8510.

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