Deducting casualty losses after a natural disaster
Tax Facts Q&A: What is considered a casualty loss, and what limitations apply when taxpayers claim a casualty or theft loss deduction?
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Editor’s note: Under the 2017 Tax Act, individuals are no longer entitled to deduct casualty and theft loss expenses as itemized deductions (when those losses are not related to property used in a trade or business). An exception exists for losses that occur in federally declared disaster areas. However, if a taxpayer has personal casualty gains, the new rules do not apply (even if the loss does not occur in a federal disaster area) so long as the losses do not exceed the gains. This essentially means that casualty losses will continue to offset casualty gains. This provision applies for tax years beginning after December 31, 2017, and before January 1, 2026. The rules outlined below generally apply for tax years beginning before 2018 and for losses that are sustained in a disaster area.
Question: What is a casualty loss?
Answer: A casualty loss is a loss that an individual taxpayer suffers as a direct result of an event that meets the following criteria:
(1) It is identifiable;
(2) It is damaging to property; and
(3) It is sudden, unexpected, and unusual in nature.
IRC Section 165 specifically permits a casualty loss deduction for fire, storm, shipwreck or “other casualty.” The term “other casualty” has been interpreted to include damage sustained as a result of, among other events, floods and sudden freezing. Other deductible casualty losses that are specifically allowed by the IRS include damage caused by fire, earthquake, government-ordered demolition or relocation of a home rendered unsafe due to a disaster, mine cave-ins, shipwrecks, sonic booms, storms, terrorist attacks, vandalism and volcanic eruptions.
The Tax Court allowed a taxpayer’s casualty loss deduction for damage caused by blasting operations when the damage caused by the particular blast was unusual and heavier than the blasting that had occurred on a day-to-day basis in the area. The Tax Court has also permitted a casualty loss deduction for damage sustained due to vandalism, because the vandalism in question was caused by persons outside of the taxpayers’ control, was sudden in nature, and destructive in effect.
Damage to property created by termite infestation was not considered to be a casualty loss, because the damage was created by a progressive deterioration of property resulting from a steady cause operating over time — essentially, the casualty loss deduction was denied because the event that caused the destruction was not “sudden” in nature.
A taxpayer was not entitled to claim a casualty deduction for losses sustained as a result of the worthlessness of currency held by the taxpayer. The Tax Court found that “other casualty” must be interpreted to mean an event similar to “fire, storm or shipwreck” and that a decrease in currency value was not a similar event. Further, the court noted that the taxpayers actually still held the currency at issue — thus, it was not technically damaged.
Further, costs incurred by a taxpayer in order to prevent a potential casualty loss are not deductible under IRC Section 165 as casualty losses. According to the courts, such preventative steps are not sudden and unexpected in nature, and thus, do not qualify as events giving rise to casualty loss treatment.
Special rules apply if a taxpayer suffers a casualty loss within a federally declared disaster area. Generally, casualty losses are deductible during the taxable year that the loss occurred.
Question: What limitations apply to the amount a taxpayer is able to claim as a casualty or theft loss deduction?
Answer: Casualty and theft losses are deductible whether the loss relates to property held by the taxpayer (i) for use in a trade or business, (ii) for investment purposes, or (iii) for use that is purely personal. However, if the property involved is not held for a business or profit-generating purpose, the amount of the deduction is limited as follows:
- Each loss is reduced by $100 and any insurance proceeds received (prior to 2010, the $100 limitation was $500); and
- The aggregate of such adjusted losses is deductible only to the extent that it exceeds 10% of adjusted gross income.
If the taxpayer sustains more than one loss from a single casualty event, only one $100 reduction is made. Conversely, a separate reduction of $100 is made for losses from each casualty or theft event. The 10% limit applies to the total of all of the taxpayer’s losses from all casualty events occurring in the same tax year.
When casualty and theft losses exceed income for the tax year, the excess is considered a net operating loss and may be carried back to offset income in prior years and carried forward to offset income of future years under the net operating loss provisions. All casualty and theft losses qualify even though the property is personal.
The amount of the loss which can be deducted above the $100 floor is limited to the lesser of (1) the difference between the fair market value of the property immediately before the casualty, and the fair market value immediately after the casualty, or (2) the adjusted basis of the property. This amount is further reduced by any insurance or other indemnification received. In addition, as discussed above, such loss is deductible only to the extent it exceeds 10% of adjusted gross income.
Example: Cathy and Bernardo owned a group of apartment buildings that were damaged by flooding. Before the flood, the adjusted basis in the apartment buildings was $672,000. The fair market value of the property immediately prior to the flood was $2 million and immediately after the flood was $750,000. Cathy and Bernardo received $767,000 from insurance coverage. Although the $1,250,000 decline in market value far exceeded the insurance recovery, no casualty loss deduction is allowable since the insurance proceeds exceeded the adjusted basis in the property.
William H. Byrnes and Robert Bloink are co-authors of Tax Facts. They can be reached at taxfactshelp@alm.com.
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