Always Consult Your Accountant Before Making Tax Decisions
Hurricane Sandy caused unprecedented and extensive damage to property and businesses in the Tri-State Area. If storm-related damage was sustained to a home, personal property, rental property or a business, the federal tax law may allow the affected taxpayers to claim a deduction on their tax return.
This article focuses on property where the reported loss is on an individual income tax return. The ability to deduct the loss relates to several factors, including the nature of the property that sustained damage, the potential for recovery from insurance, whether the property was located in a declared federal disaster area, and whether the damage was complete or partial.
What Type of Property Do I Own?
For tax purposes, casualty losses are divided into three categories of property and the treatment of losses is distinct for each group. One category is business property and includes equipment, a factory building, or even goodwill from an active trade or business. The second category is income-producing property, which is generally investment property that can be real or personal property such as artwork and investment real estate. The third type of property is property held for personal use, such as a home, car, boat or furniture. There are certain ambiguities between the various property types and a fuller explanation of these differences is beyond the scope of this article. Items of mixed use, such as property used for both personal and rental purposes, and the vacation-home rental rules are examples of these ambiguities. You should consult a tax advisor for help in dealing with the intricacies of these rules.
How Much is My Casualty Loss?
For business or income-producing property that was completely destroyed, the loss is limited to the adjusted basis of the property at the time of the casualty event. For business and income-producing property that sustained partial damage or personal-use property either completely destroyed or partially damaged, the calculated loss is the lesser of the adjusted basis of the property or the decline in the fair market value of the property as measured before and after the casualty event. An appraisal is generally required to determine the "before and after" fair market values. Courts have upheld that a casualty that permanently decreases the fair market value of a property can be claimed as a casualty loss even if minimal actual damage was caused to the property itself. Consider the example of a beach house that was worth $5 million before a severe flood. There was only $200,000 of physical damage to the property but, due to permanent impairment to the neighborhood, the fair market value of the property is $3 million after the flood. Courts have accepted that $2 million is the permissible casualty loss deduction as long as the impairment to the value of the home relates to permanent factors and is not transitory in nature.
An alternative way to measure the casualty loss is the cost of repair. This alternative method can be used for less extensively damaged items as long as the repairs do not increase the value of the property to an amount greater than that before the casualty. Also the repairs cannot be made to items that were not actually damaged.
Where Do I Claim The Loss on My Tax Return?
On an individual tax return, casualty losses claimed for personal-use property and income-producing property are treated as itemized deductions. The loss amount for personal-use property must first be reduced by $100 and then by 10% of adjusted gross income (AGI) to determine the amount allowed as an itemized deduction. The 10%-of-AGI limitation prevents many taxpayers from claiming a casualty loss for personal-use property. By comparison, income-producing property is not subject to this limitation. Care must be taken to properly categorize between personal-use and investment property to maximize the deductibility of casualty losses. Losses claimed for business property are deductible in full as a reduction for AGI, an even more favorable tax treatment. For those taxpayers who are concerned about the AMT, the casualty loss is allowed under both the regular and AMT taxing regimes for all types of property.
How Does Insurance Affect My Casualty Loss Amount?
Many valuable items are insured in case of an unexpected loss due to a major storm or other catastrophe. If a personal-use property item that is being claimed as a casualty loss was insured either in whole or in part, a claim must be filed with the insurance company in order to claim a deduction for the insured portion. Likewise, you must exclude any expected reimbursement from the calculated loss. For example, if a car recently purchased for $40,000 was completely destroyed, but was only insured for $30,000, then the casualty loss deduction allowable is $10,000 as the additional $30,000 loss is expected to be recovered through insurance. Should the insurance not pay that amount, a subsequent casualty loss deduction could be claimed for the amount denied by the insurance company. If you do not file an insurance claim, then only $10,000 would be calculated as the loss regardless of whether the insurance company denied the claim. If a taxpayer underestimates the amount of insurance reimbursement, any excess is treated as income when it is actually received. In our example, if the insurance company decided unexpectedly to pay $35,000, the taxpayer would have to pick up the additional $5,000 as income in the year it is received if a $10,000 loss was taken initially.
What Are Benefits of a Federal Disaster Area Designation?
The President has the authority to declare certain areas as Federal Disaster Areas, which can accelerate a tax refund claim when claiming a casualty loss. The idea behind this is if a casualty loss occurred in a Presidentially Declared Federal Disaster Area, the victims of such a large tragedy may be in immediate need of cash to rebuild and repair. Thus, the federal government allows a casualty loss claim to be effective for the tax year immediately preceding the tax year in which the casualty event occurs. Many areas in New York, New Jersey, and Connecticut that were affected by Hurricane Sandy were declared Federal Disaster Areas and, while Hurricane Sandy occurred in tax year 2012, a casualty loss can be claimed for tax year 2011 if the casualty took place in one of those designated areas. This keeps the taxpayer from having to wait until their 2012 tax returns are filed in 2013 to claim the deduction. Since the 2011 tax deadline passed for most calendar year taxpayers on October 15, 2012, an amended return can be filed to claim an immediate refund. The taxpayer has three years from the due date of a return to file an amended return and claim a refund. Importantly, claiming the loss in the prior year is at the election of the taxpayer for disaster area losses. He or she can choose the tax year in which the loss is claimed. If the Hurricane Sandy-loss occurred in a location not declared a disaster area then the loss can be claimed only for the 2012 tax year.
Can a Casualty Loss Generate a Net Operating Loss (NOL)?
Large assets that are lost due to a storm may generate unreimbursed losses that exceed income in the year that the loss is being claimed. Regardless of whether the casualty loss relates to business, income-producing activity or personal-use assets, the loss can generate a Net Operating Loss (NOL), which can be carried to other tax years -- backwards or forwards. Further, although general losses from passive activities may be suspended under the passive activity loss rules, the tax code provides that losses that meet the casualty requirements are not considered passive activity losses and are fully allowable.
What is My Cost Basis Going Forward After Claiming a Casualty Loss?
Once a loss has been claimed for an asset, the taxpayer needs to know what the basis of that asset will be going forward. The basis of the asset must be adjusted downward by the amount of the loss claimed. If a taxpayer were to claim a $500,000 casualty loss on a property whose adjusted basis before the casualty event was $700,000, the basis immediately after taking the loss would be $200,000.
Operating Business - Goodwill
The tax treatment of a casualty loss from an operating business is complex. As mentioned earlier, the general rule is that the loss allowable is equal to the change in the fair market value before and after the casualty event, but limited to the adjusted basis in the property. The fair market value of many businesses may include a significant amount of goodwill. A loss could be based on the permanent impairment of goodwill resulting from the casualty event. Professional tax advice should be sought when dealing with business casualty losses involving goodwill.
While the ugly side of natural disaster may cause immediate turmoil and distress, it is important to know that there are options available through the tax code to help speed up the recovery process. The tax treatment of casualty losses is complex and the distinction between property categories is not always clear. In times of distress, quickly claiming a cash tax refund can accelerate rebuilding a home or business. A tax advisor can navigate this process with you and assist in your recovery effort.
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.