Isabel puts casualty loss tax relief in spotlight

With the right planning, victims of hurricane could get much needed help

By Jim Wilhelm, CPA

Hurricane Isabel left her mark throughout the Mid-Atlantic region, damaging homes and businesses and disrupting the lives of millions.

Once the damage has been assessed, some careful record keeping performed now could produce significant tax relief for those impacted by the storm.

The following is a general summary of the income tax rules related to casualty loss deductions and other related tax relief.

Definition of a casualty loss

A casualty loss is defined as "damage, destruction or loss of property resulting from an identifiable event that is sudden, unexpected or unusual." Damage from gradual or progressive deterioration of property over a period of time does not qualify for a casualty loss deduction. The sudden damage caused by Isabel should certainly qualify as a casualty loss, unless there was prior damage to the property.

Examples of events that qualify include:

acts of nature such as hurricanes, tornadoes, floods, storms and volcanic eruptions;
shipwrecks and sonic booms;
vandalism;
fires (unless set by the taxpayer);
loss of funds due to a bank's insolvency;
car and other accidents that aren't due to willful negligence or breakage under normal conditions;
theft;
under certain conditions, damage from sudden, unexpected or unusual smog or infestation by insects.

Business vs. non-business property

Once it has been determined that a casualty loss has occurred, the next distinction that must be made is whether the damaged property was used in a business or non-business (personal use) capacity. The amount of any deduction and methods of accounting for and reporting the deduction are dependent upon the type of loss.

Non-business property

For non-business property — such as a personal residence, second home, trees on a residential lot, household contents and personal automobiles, etc. — the amount of the casualty loss is the smaller of the decrease in fair market value of the property caused by the casualty, or the adjusted basis of the property. Taxpayers cannot deduct more than their cost invested in the property, even if the fair market value of the property has increased since they acquired the property.

For example, a taxpayer purchased a painting for $1,000, which was totally destroyed by water damage. At the time of the casualty, the painting was worth $5,000. Assuming there was no insurance coverage or other recovery available to the taxpayer, his or her casualty loss would be limited to $1,000 — the decrease in fair market value of the property caused by the casualty ($5,000 down to $0), limited to the adjusted basis in the painting ($1,000).

The deductible casualty loss is then reduced by insurance proceeds or other reimbursements received. Costs incurred for cleaning or repairing property, temporary housing, rental property expenses and other incidental expenses are not part of the deductible casualty loss.

Determining the loss in fair market value (FMV) can be problematic. FMV before and after the casualty event occurs must be documented and proven. Typically, appraisals by competent professionals should be obtained. Before-and-after photographs also can be helpful, much as they are for submitting insurance claims.

Damage to landscaping, trees, shrubbery and the like is more difficult to substantiate than other property damage, such as damage to homes, automobiles and furniture. There are, however, professional resources and guidelines available for taxpayers seeking damage estimates for casualties related to downed trees and the like. These include arborists, tree and landscape appraisers and professional foresters.

Although the cleanup and repair costs are not directly part of a casualty loss deduction (as noted above), they can be a factor in the decrease in FMV computation. If repairs and cleaning costs are not excessive and they do not increase the FMV of the property beyond its value and condition prior to the casualty, these expenses may be used as a measurement of FMV loss. In other words, if it took $1,000 to repair a damaged automobile to its pre-casualty condition, this repair expense could be a factor in determining the loss of value due to a casualty.

Therefore, it is imperative that property owners document losses as soon as possible after the event, gather cost basis data and properly account for insurance or other recoveries.

Non-business loss limitations

The amount of casualty loss available for deduction (after insurance and other reimbursements are taken into account) is subject to further limitation. The deductible loss for non-business casualty losses must be reduced by a $100 "deductible" and 10 percent of the taxpayer's adjusted gross income (AGI). The deductible loss can then be taken only as an itemized deduction included on the taxpayer's Schedule A.

For example, the taxpayer had a net casualty loss of $20,000. Her AGI was $80,000. The amount of the deduction would be $11,900. That figure is computed by taking the net loss after insurance proceeds ($20,000) and subtracting the $100 floor / deductible and the 10 percent AGI reduction ($8,000 — that's 10 percent of her AGI of $80,000).

Federal disaster area designation

President Bush has declared many parts of the Mid-Atlantic area as federal disaster areas. In addition to federal funds that will be provided to the effected states and low-cost loans available to those affected by Isabel, this designation provides some additional casualty loss tax benefits to taxpayers.

Non-business casualty loss deductions typically are claimed on taxpayers' returns for the year in which the loss occurred. If located within a designated disaster area, taxpayers may choose between taking the loss on their 2003 returns or amending their 2002 returns. Why would they amend the 2002 return? They would receive a tax benefit in the form of a refund sooner than if they had waited until they filed the 2003 return in 2004. If the taxpayer's AGI was lower in 2002 than it will be in 2003, the deduction also could be more valuable on the 2002 return because of the 10 percent AGI limitation.

An additional benefit is an extension of time to purchase certain replacement property and defer any tax gain incurred from two years to four years. Although it might sound odd, taxpayers can actually face a tax bill from a casualty. (More on that issue below.)

Business property

If the casualty causes damage to property used in a trade or business — i.e. for the production of income — the casualty loss is computed in much the same manner as non-business losses, with several important distinctions: There is no deduction limit, there is no $100 floor / deductible per event and no 10 percent of AGI reduction, and the loss is not reportable as an itemized deduction. Therefore, the entire loss (after adding back any insurance or other reimbursement) is fully deductible.

Incidental costs for cleanup, repairs, temporary property rentals, etc., may also be deducted as current period expenses. Major repairs and replacements may have to be capitalized and deducted over a period of years if the repair or replacement extends the life of the property or its fair market value beyond its condition prior to the casualty event. If the business property was in a federal disaster area, the extra relief for choosing which year to take the loss and the extended replacement period apply as well.

Business property with no cost basis — fully depreciated equipment, expensed supplies, growing crops, livestock, etc. — generally would not have casualty losses.

Tax deferral of casualty gains

A casualty might actually create a gain rather than a loss for a taxpayer. For business property, this is most often the case when insurance proceeds exceed the remaining adjusted basis of the property damaged in a casualty.

If a net gain does result, whether with business or non-business property, income taxes on the gain can be deferred under Internal Revenue Code 1033 if the gain is reinvested in qualifying like-kind property. Taxpayers have two years to acquire such replacement property, subject to certain exceptions for property located in a federal disaster area. The election to defer any casualty gain is made with the tax return in the year the casualty event occurred, or the taxpayer must recognize the casualty gain as taxable income.

Caution should be exercised in this situation since there are complex rules for like-kind property, the amount of gain that may be deferred and other issues.

Reduction of tax basis

When a casualty loss is deducted, the taxpayer must reduce the adjusted basis in the property by the amount of the loss taken. If the property is totally lost or destroyed, this is irrelevant. For partial losses, tax records must reflect this adjustment to the basis of the property.

State and local tax relief

Income tax relief is available in most states, especially those that generally follow the federal rules for income taxation and those allowing itemized deductions for individual taxpayers.

In Maryland, there are several relief opportunities for taxpayers who have lost or damaged property relating to real and personal property taxes. Each state and taxing jurisdiction has its own rules, but all opportunities should be explored.

Summary

Tax relief from losses due to Isabel is somewhat complex. The different rules for business and non-business property, loss limitations, choice of year in which to take the loss, and issues regarding adjusted tax basis require expert advice from a tax professional.

Editor's note: Jim Wilhelm is a partner with Stout, Causey & Horning, P.A.

Contact this Author: < James Wilhelm > jwilhelm@scandh.com

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