Personal casualty losses from natural disasters

By Howard Godfrey, CPA, Ph.D.

PHOTO BY TERRAY SYLVESTER/REUTERS
PHOTO BY TERRAY SYLVESTER/REUTERS
 

EXECUTIVE
SUMMARY

 
  • A deduction is allowed for losses arising from fire, storm, or other casualty, or from theft, that are not incurred in a trade or business or in a transaction entered into for profit (a personal casualty or theft loss). Each such loss is allowed only to the extent it exceeds $100, and net total losses for a year may be deducted only to the extent they exceed 10% of adjusted gross income.
  • Under the legislation known as the Tax Cuts and Jobs Act of 2017, P.L. 115-97, a personal casualty loss is deductible only if it is attributable to a federally declared disaster.
  • In an exception to the general rule, personal casualty losses not attributable to a federally declared disaster are deductible to the extent of personal casualty gains in tax years 2018 through 2025.
  • Legislation earlier in 2017 provided relief from certain requirements for taxpayers with casualty losses from hurricanes Harvey, Irma, and Maria. In addition, the IRS provided several safe-harbor methods for calculating the amount of casualty losses, some targeted to damage from the hurricanes, some for federally declared disasters, and others applicable still more generally.
  • Taxpayers may elect to claim a disaster loss deduction in the tax year immediately preceding the year of the disaster. A casualty loss deduction may also result in a net operating loss for the tax year.

Many taxpayers have had reason in recent years to claim casualty losses caused by hurricanes, wildfires, and other natural disasters. Sixteen disasters each caused over $1 billion in damage in the United States in 2017. Hurricane Harvey damaged or destroyed over 200,000 homes and businesses.1 Harvey also damaged or destroyed as many as 500,000 vehicles in Houston alone, and Hurricane Irma destroyed perhaps an equal number in all affected areas.2 Many of these losses have been of property other than that used in a trade or business or for the production of income and thus potentially claimable as personal casualty losses.

This article explains the federal tax rules for calculating and reporting the deduction for losses of residential property and other nonbusiness property from natural disasters. Recent changes to the law and IRS guidance have made significant changes to these rules. These include, on the one hand, recent legislation and revenue procedures expanding or facilitating taxpayers' ability to claim personal casualty losses but also, on the other hand, the general limitation of the deduction of personal casualty losses to those resulting from federally declared disasters, under the tax reform law known as the Tax Cuts and Jobs Act (TCJA).3

Loss allowed under Sec. 165

Sec. 165(a) provides a deduction for a loss sustained by a taxpayer to the extent that the taxpayer does not receive insurance proceeds or other compensation for the loss. The basis used to compute the loss is the adjusted basis for determining loss on sale or other disposition of the property under Sec. 1011.4

Loss deductions for individuals

For an individual, a loss deduction is allowed under Sec. 165(c) only for:

  • Losses incurred in a trade or business;
  • Losses in a transaction entered into for profit but not connected with a trade or business; and
  • Other losses (i.e., not incurred in a trade or business or in a transaction entered into for profit) that arise from fire, storm, shipwreck, other casualty, or theft.

This article refers to the first two types of losses described above as "business or investment" losses involving business or investment property. The third, other losses, are called "personal" casualty or theft losses. If personal casualty gains for the year exceed personal casualty losses, the gains are treated as capital gains and the losses are treated as capital losses, under Sec. 165(h)(2)(B).

Personal casualty loss limits for individuals

For an individual, Sec. 165(h)(1) provides that each personal casualty or theft loss is allowed only to the extent it exceeds $100. Thus, a personal casualty loss of $100 or less is disregarded. In addition, under Sec. 165(h)(2), when personal casualty losses exceed personal casualty gains for the year, the net total casualty losses are deductible only to the extent that they exceed 10% of the individual's adjusted gross income (AGI). Under Sec. 165(h)(5), added by the TCJA, a net personal casualty loss in calendar years 2018-2025 is deductible only to the extent it is attributable to a federally declared disaster. During this period, casualty losses that are not attributable to a federally declared disaster are deductible only to the extent of casualty gains.

Hurricanes Harvey, Irma, and Maria

Congress has provided special relief in the Disaster Tax Relief Act5 for individuals with casualty losses from hurricanes Harvey, Irma, and Maria. There is a waiver of the requirement to reduce a personal net casualty loss deduction by 10% of AGI, but the $100 floor per casualty loss is increased to $500. A taxpayer's standard deduction is increased by the amount of a net disaster loss (a net casualty loss arising in the hurricane Harvey, Irma, or Maria disaster area).A taxpayer may realize more benefit by taking the standard deduction than by itemizing. IRS administrative safe harbors for computing the amount of casualty losses are described later in this article.

Amount of a casualty loss

Regs. Sec. 1.165-7(b) provides that the amount of a business or investment casualty loss, or a personal casualty loss, is the lesser of:

  • The fair market value (FMV) of the property immediately before the casualty, minus the FMV immediately after the casualty; or
  • The adjusted basis for determining the loss on the sale or disposition of that property.

However, if business or investment property was totally destroyed, and its FMV immediately before the casualty is less than its adjusted basis, the amount of the loss is equal to the property's adjusted basis (see the table "Casualty Loss for Auto" below).

Casualty loss for auto

Documenting the change in value

The FMV of property before and after a casualty event is generally determined from a competent appraisal. Under Regs. Sec. 1.165-7(a)(2)(i), a casualty loss deduction is limited to the decline in value of the property caused by the casualty. A flood or other casualty may cause potential buyers to anticipate possible future disasters, resulting in a general decline in property values in the area. Such a decline in value is not part of the casualty loss. In Bird,6 the Tax Court accepted the amount paid for a residence less than a year before the casualty, plus the cost of improvements, as the pre-casualty value. In Woods,7 the court accepted the selling price of a home sold soon after it was damaged by drought-related soil subsidence as a better measure of its value immediately after the casualty than an appraiser's opinion.

Repair cost as evidence of a decline in value

The cost of repairs to damaged property may be accepted as evidence of the decline in value under Regs. Sec. 1.165-7(a)(2)(ii) if:

  • The repairs are necessary to restore the property to its pre-casualty condition;
  • The amount spent for repairs is not excessive;
  • The repairs are limited to the damage sustained in the casualty; and
  • The repairs do not cause the value of the property to exceed its pre-casualty value.

Generally, the decrease in the value of the property may be determined using the cost-of-repairs method only if the taxpayer in fact repairs the property. In Lamphere,8 the taxpayer was not allowed to use estimates of repairs that would be performed in the future or might not be performed at all. However, exceptions to this rule are provided in some safe harbors described later. The taxpayer may not include any repairs provided at no charge, such as those made by community volunteers, etc.

Definition of a casualty loss

The IRS and the courts have developed the overall concept that a casualty refers to an identifiable event of a sudden, unexpected, or unusual nature. For example, in Rev. Rul. 76-134, the IRS states that damage to buildings, docks, seawalls, etc. from winds and wave action during a storm may qualify as a casualty loss. However, progressive deterioration of property over time does not qualify as a casualty loss. Thus, damage to buildings, docks, and seawalls from gradual erosion does not qualify as a casualty loss under Sec. 165. The IRS also states in Rev. Rul. 76-134 that a casualty loss deduction is not allowed for amounts spent to move a house from its original location to a safer location, or for the cost of taking protective measures such as erecting barriers. Such costs are capitalized under Sec. 263. In Getz,9 the Tax Court allowed a single casualty loss deduction for multiple storms occurring in a short period. The taxpayers were not required to document the amount of the loss from each storm.

In Pulvers,10 the taxpayers' residence sustained no physical damage, but its value declined because three nearby residences were ruined by a mudslide. A casualty loss deduction was not allowed for this decline in value, which was caused by potential buyers' fear that a mudslide might damage the residence in the future.

Separate computation for each property

Regs. Sec. 1.165-7(b)(2) provides that a loss of business or investment real property is computed separately for each identifiable property and property improvement that is damaged or destroyed. For example, when a business building and adjacent ornamental trees are damaged, a loss is computed separately for the building and for the trees. If the building was not used in a trade or business or an investment activity, a taxpayer reports a single amount as the loss from the building and the trees (see the tables "Casualty Loss, Office Building Acquired in 2014" and "Same Property Used as a Residence," below).

Casualty loss, office building acquired in 2014

Insurance proceeds and other assistance

Sec. 165(h)(4)(E) provides that a personal casualty loss that is covered by insurance is taken into account only if the individual files a timely insurance claim for the loss. The amount of loss not covered by insurance is deductible. If the taxpayer claims a deduction for a loss and receives a reimbursement for the loss in a later year, the reimbursement is included in income of the year received, subject to the tax benefit rule under Sec. 111. In Rev. Rul. 71-160, a taxpayer deducted a casualty loss and then acquired a government disaster loan. The loan was partly canceled because the loss had not been fully covered by insurance. The taxpayer was required to include the amount of loan cancellation in income on the tax return for the year after the casualty.

An individual may receive insurance payments to cover additional living costs when a residence is damaged or when the individual is denied access to the residence by a government agency because of a casualty or a threat of a casualty. Such payments are excluded from income under Sec. 123 to the extent the actual living expenses exceed the normal living expenses that would have been incurred by the taxpayer and members of the household for the period. Rev. Rul. 98-19 provides that payments received from a government agency for the cost of moving from a flood-damaged residence to another residence are not included in income. Rev. Rul. 64-329 provides that a taxpayer who receives gifts that are excluded from income does not reduce the loss deduction by the amount of those excluded gifts, unless the funds are required to be used for repair costs.

Safe harbors for computing certain losses

Taxpayers often face challenges when determining the amount of casualty losses. Records are often destroyed in a disaster, and existing records may be difficult to locate. The IRS recently issued two revenue procedures containing safe harbors to assist taxpayers in determining the amount of deductible losses from casualties or thefts. Some of these safe harbors are available for a loss incurred only (1) in any federal disaster area, or (2) only from hurricanes Harvey, Irma, and Maria. Sec. 165(i) defines "federally declared disaster," a "disaster area," and a "disaster loss."11

When a taxpayer qualifies for and uses a safe harbor to compute a casualty or theft loss, the IRS will not challenge the amount of the loss deduction. A safe-harbor method simplifies the process of computing a loss deduction and may eliminate the need for costly litigation. A taxpayer may choose to use a safe-harbor method or compute the actual loss under applicable regulations. In Section 6 of each of the revenue procedures described below, the IRS requires a safe-harbor loss amount to be reduced by any no-cost repairs provided by volunteers, etc.

Care is needed when using the safe harbors described below. After computing a loss, it is necessary to consider the limitations of Sec. 165(h). As explained earlier, the Disaster Tax Relief Act modified the limitations for losses from hurricanes Harvey, Irma, and Maria.

Rev. Proc. 2018-8 provides that any costs that cause the property's value to be higher than its pre-casualty value are excluded from the estimates or contracts used in the safe harbors it provides, even if those costs are necessary to meet new construction requirements.

Safe harbor for residential real property in all areas under Rev. Proc. 2018-8

Rev. Proc. 2018-8 provides five safe-harbor methods for a loss of "personal-use residential real property," which is defined as real property including improvements that include at least one personal residence. The term does not include a personal residence if any part of the residence is used as rental property, as a home office for a trade or business, or in a transaction entered into for profit. Three of the safe harbors may be used without respect to whether the property is in a disaster area or damage is due to a federally declared disaster.

An "estimated repair cost safe harbor method" may be used to determine the decrease in the value of an individual's personal-use residential real property where the loss is not more than $20,000. The taxpayer uses the lesser of two itemized repair cost estimates prepared by two separate and independent licensed or registered contractors.

A "de minimis safe harbor method" allows the taxpayer to estimate the cost to restore the personal-use residential real property to its condition before the disaster, but this method is available only for losses of $5,000 or less. This must be a good-faith estimate based on records maintained by the taxpayer.

With the "insurance safe harbor method," the amount of the loss is based on reports prepared by the individual's homeowner or flood insurance company setting forth the estimated loss that the individual sustained.

Disaster area safe-harbor losses under Rev. Proc. 2018-8

Taxpayers with losses in federal disaster areas that are due to a federally declared disaster may also use a "contractor safe harbor method" or a "disaster loan appraisal safe harbor method." The first method involves the contract price for a detailed list of repairs under a binding contract with an independent contractor (signed by the taxpayer and the contractor). The second method involves the use of an appraisal prepared to obtain a federal loan or federal loan guarantee.

Safe harbor for personal belongings under Rev. Proc. 2018-8

A "de minimis safe harbor method" is available for a loss of $5,000 or less of personal belongings. With this method, the individual makes a good-faith estimate of the decrease in FMV, based on the taxpayer's records describing the belongings.

A "replacement cost safe harbor method" is available for computing an individual's casualty or theft loss of personal belongings in a federal disaster area. The taxpayer determines the cost to replace each personal belonging with a new one and then reduces that replacement cost by 10% for each year (up to nine years) the item was owned. The safe-harbor value of an item that has been owned nine or more years is 10% of the current replacement cost. The loss for each item (before considering insurance proceeds) is the excess of its adjusted replacement cost over the value after the casualty, which will be zero for lost or stolen items. The deductible amount, before any reimbursement, is the lesser of this value or the asset's basis.

Example: A couch that cost $700 four years ago was destroyed in a hurricane in a federally declared disaster area. It was not insured. The adjusted replacement cost factor is 60%, which is 100% less 10% per year of ownership. Today, the couch has a replacement cost of $1,000. The loss is $600, based on a 60% factor. Since this amount is less than the basis of $700, the casualty loss is $600.

If adopted, this method must be used for all losses of personal belongings in the disaster area, except those described in the next paragraph.

The replacement cost safe-harbor method is not available for a loss of a boat, aircraft, mobile home, trailer, vehicle, or an antique or other asset that maintains or increases its value over time. The pre-disaster value of those assets can be determined from established pricing sources.12

Safe harbor for 2017 hurricanes under Rev. Proc. 2018-9

Due to the widespread devastation in 2017 from hurricanes, the Treasury Department and the IRS published seven additional safe-harbor methods in Rev. Proc. 2018-9. These safe-harbor methods may be used by individuals to compute casualty losses of personal-use residential real property located in the "2017 disaster area." That area includes the entire states of Texas, Louisiana, Florida, Georgia, and South Carolina, as well as the Commonwealth of Puerto Rico and the territory of the U.S. Virgin Islands. These safe harbors apply only to losses from hurricanes Harvey, Irma, and Maria.

The use of a safe-harbor method in Rev. Proc. 2018-8 and/or Rev. Proc. 2018-9 is not mandatory. A taxpayer may instead compute the reduction in value of personal-use residential real property under Regs. Sec. 1.165-7(a)(2).

'Cost indexes' safe-harbor method under Rev. Proc. 2018-9

Rev. Proc. 2018-9 provides a "cost indexes safe harbor method." Individual taxpayers may use this method in determining the amount of their casualty losses (decline in value) for personal-use residential real property in the 2017 disaster area, identified above. Three tables contain safe-harbor "cost index amounts" per square foot of a residence. The first table provides cost index amounts for each of the states and territories for a "total loss" of a small, medium, or large residence.

The table "Total Loss Under Rev. Proc. 2018-9" illustrates the loss computation for an individual who incurred a total loss of a 2,000-square-foot personal residence in Florida from Hurricane Irma.A second table in Rev. Proc. 2018-9 provides similar safe-harbor information (index amounts) for a home where there is a "near total loss."13 A third table provides similar information for cases involving interior flooding of the home. In the third table, the loss is based on the area of the home that was flooded.Only one of the three tables may be used for a single residence.

Additional tables provide cost index amounts per square foot for these losses: structural damage from wind, rain, or debris; roof damage from wind, rain, or debris; damage to a deck; and damage to a detached structure.

Total loss under Rev. Proc. 2018-9

Election to take a prior-year deduction for a disaster loss

Sec. 165(i) provides an election that allows a taxpayer who has sustained a loss from a federally declared disaster in a disaster area to claim the loss deduction on the tax return for the year prior to the disaster year. Temp. Regs. Sec. 1.165-11T(d) provides that such an election applies to the entire loss incurred by the taxpayer from the disaster, and, if the election is made, no part of the loss may be deducted on the tax return for the disaster year.

The amount of the loss taken on the prior-year return is limited to the uncompensated loss, based on the facts on the date the taxpayer claims the loss. A homeowner in a disaster area may be required to demolish a residence that is determined to be unsafe. If the taxpayer is ordered to demolish the residence within 120 days after that determination, the loss is treated as a casualty loss in the disaster area under Sec. 165(k).

Making the election

Temp. Regs. Sec. 1.165-11T(f) provides that an election to deduct a casualty loss on a prior-year tax return must be filed no later than six months after the due date for filing the federal income tax return for the disaster year (determined without regard to any extension of time to file). If the disaster occurs before the prior-year tax return is filed, the loss deduction may be claimed on the original return for that year. If not, the deduction may be claimed on an amended prior-year tax return. If the deduction has been claimed on the casualty-year tax return, Temp. Regs. Sec. 1.165-11T(d) requires that the return be amended to remove the casualty loss deduction on or before the date the taxpayer makes the election under Sec. 165(i).

Revoking an election

A taxpayer who has elected to claim the deduction on the prior-year tax return may revoke that election and claim the deduction on the return for the disaster year. Temp. Regs. Sec. 1.165-11T(g) provides that the deadline for revoking the election is 90 days after the due date for making the election. The taxpayer must amend the prior-year return and remove the casualty loss deduction before the taxpayer files the return or the amended return for the disaster year that includes the loss.

Casualty loss can create net operating loss

A taxpayer may benefit from both a casualty loss deduction and a net-operating-loss (NOL) deduction. If the casualty loss deduction exceeds taxable income (before considering the casualty loss), an NOL is created. An NOL incurred before 2018 may be carried back two years and forward 20 years. Sec. 172(b)(1)(A), as amended by the TCJA, provides that there is no carryback for an NOL incurred after 2017, but the loss may be carried forward indefinitely.

Personal casualty losses after 2017 restricted to disasters

For tax years beginning after Dec. 31, 2017, and before 2026, Sec. 165(h)(5), added by the TCJA, provides that a personal casualty loss will be allowed only if the loss is attributable to a federally declared disaster. Such personal casualty losses that are allowed after 2017 remain subject to the Sec. 165(h) limits described above for personal casualty losses. However, an exception to this rule applies if the taxpayer has personal casualty gains. In that case, under Sec. 165(h)(5)(B)(i), the taxpayer may deduct personal casualty losses that are not attributable to a federally declared disaster to the extent of the personal casualty gains.

Gain recognition

When a taxpayer incurs damage to a residence that has appreciated since acquisition, the amount of insurance coverage may be more than the basis but less than the current value. A gain may be realized, even if insurance proceeds are less than the cost of repairs or reconstruction (see the table "Gain From Insurance Proceeds" below).

No gain is recognized on insurance proceeds received for "unscheduled" personal property contained in the taxpayer's principal residence in a federal disaster area that was compulsorily or involuntarily converted as a result of a federally declared disaster.14 Any other insurance proceeds are treated as received for a single asset, and any similar replacement property is also treated as a single asset.15 A gain realized on an involuntary conversion of a primary residence may be partly or fully excluded under Sec. 121.16 If the amount of the gain realized on a primary residence exceeds the allowable Sec. 121 exclusion, the excess gain may be deferred under Sec. 1033.

A taxpayer may elect to recognize a gain only to the extent that the insurance proceeds exceed the cost of replacement property. When this election is made for a principal residence or its contents in a federal disaster area that are compulsorily or involuntarily converted as the result of a federally declared disaster, gain is deferred if the taxpayer purchases replacement property within four years after the end of the first tax year in which any part of the gain is realized.17 The basis of replacement property is equal to its cost, minus the amount of casualty gain that is deferred under Sec. 1033.

Gain from insurance proceeds

Guidelines for claiming a casualty loss

  • Maintaining cost and other information is critical when documenting and defending a casualty loss deduction. Often, the deduction is limited or even disallowed completely because the taxpayer is unable to document the amount of the loss.This documentation generally includes basis of the loss property. It also includes the property value before and after the casualty, or the estimated amount for repairs or the amount actually spent for repairs.
  • IRS Publication 584, Casualty, Disaster, and Theft Loss Workbook (Personal-Use Property), contains a set of blank worksheets for accumulating basis amounts and other data for assets typically found in various rooms of a house.
  • In many cases, the amount of the casualty loss may be documented by reporting repair costs, but only if those repairs have been made (unless using an applicable safe-harbor contract, estimate, or cost index method under Rev. Procs. 2018-8 and 2018-9, as described above).
  • Avoid including any costs for repairs that are unrelated to damage from the casualty. Capitalize repair costs that increase a property's value to beyond its value before the casualty.
  • Carefully analyze the options available for documenting the loss, including safe harbors.
  • Note that some safe harbors provided by Rev. Proc. 2018-8 are available for all disasters, while others are available only for losses in federally declared disaster areas. Safe harbors in Rev. Proc. 2018-9 apply only to casualty losses from hurricanes Harvey, Irma, and Maria.
  • A casualty loss may create or increase an NOL for the year. Care should be taken so that the full benefit of an NOL carryback (if allowable) or carryforward is realized.
  • Pay close attention to various deadlines for making elections and filing tax returns.   

    Footnotes

    1Rice, "Natural Disasters Caused Record $306 Billion in Damage to U.S. in 2017," USA Today (Jan. 8, 2018), available at www.usatoday.com.

    2Donnelly, "Hurricane Irma and Harvey Damaged 1 Million Cars. What Happens Now?" Fortune (Sept. 20, 2017), available at fortune.com.

    3P.L. 115-97, known as the Tax Cuts and Jobs Act of 2017.

    4Sec. 165(b).

    5Disaster Tax Relief and Airport and Airway Extension Act of 2017, P.L. 115-63.

    6Bird, T.C. Memo. 1980-156.

    7Woods, T.C. Memo. 1960-72.

    8Lamphere, 70 T.C. 391 (1978).

    9Getz, T.C. Memo. 1965-110.

    10Pulvers, 407 F.2d 838 (9th Cir. 1969).

    11A "federally declared disaster" is any disaster subsequently determined by the president of the United States to warrant assistance by the federal government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act. The term "disaster area" means the area determined to warrant such assistance. Temp. Regs. Sec. 1.165-11T(b)(3) defines a disaster loss as occurring in a federally declared disaster area, attributable to a federally declared disaster.

    12See Rev. Rul. 2002-67, which provides guidance for establishing the value of a used car. See also IRS Publication 561, Determining the Value of Donated Property. The legal definition of "value" is the same for a casualty loss determination under Sec. 165 as for a noncash charitable contribution under Sec. 170.

    13Under Rev. Proc. 2018-9, the near total loss of a personal residence occurs if, as a result of one or more of the 2017 hurricanes, "the personal residence sustained severe damage necessitating the removal and disposal of substantially all interior wall frame coverings (including drywall and other wall frame coverings), floorings, electrical lines, ducts, plumbing, and other fixtures. For a personal residence sustaining near total loss, only the wood frame, rafters, and outside facade of the personal residence remain structurally sound and reusable."

    14Sec. 1033(h)(1)(A)(i). Unscheduled personal property is property other than that which is specifically listed in an insurer's schedule of coverage.

    15Sec. 1033(h)(1)(A)(ii); Instructions for 2016 Form 4684, Casualties and Thefts, p. 3.

    16See Sec. 121(d)(5).

    17Secs. 1033(a)(2) and (h)(1)(B); Instructions for 2016 Form 4684, Casualties and Thefts, p. 3. If a gain on a principal residence is excluded under Sec. 121 and additional gain is deferred under Sec. 1033, computations described here are modified. Sec. 121(d)(5) provides that in applying Sec. 1033, the amount realized will be the amount of insurance or other compensation, reduced by the amount of gain excluded under Sec. 121. The exclusion under Sec. 121 reduces the amount that must be reinvested to defer gain under Sec. 1033.

Newsletter Articles

SPONSORED REPORT

Tax reform changes are now in effect

With all the recent tax law changes, this year it’s more important than ever to make sure your clients’ tax situations are squared away before year end. This report provides necessary guidance to ensure 2019 starts without a hitch.

DEDUCTIONS

Understanding the new Sec. 199A business income deduction

The new deduction allows certain business owners to keep pace with the significant corporate tax cut provided by the Tax Cuts and Jobs Act.