Editor: Kevin D. Anderson, CPA, J.D.
A taxpayer that incurs a loss from a federally declared disaster may elect to deduct that loss in the preceding tax year based on Sec. 165(i). On March 13, 2020, then-President Donald Trump declared the COVID-19 pandemic warranted an emergency determination under Section 501(b) of the Robert T. Stafford Disaster Relief and Emergency Assistance Act, P.L. 100-707, for all 50 states. As a result, many tax practitioners are considering the application of Sec. 165(i) and related regulations to casualty losses sustained as a result of the pandemic.
However, some questions have arisen about the application of Sec. 165(i) in the context of a global pandemic, one of which is whether a casualty loss can be claimed where there is no physical loss. Support for claiming a casualty loss in such a situation can be found in Finkbohner, 788 F.2d 723 (11th Cir. 1986), where the court held that a casualty loss may be available where there is evidence of permanent actual loss aside from physical damage. Finkbohner can be distinguished from other court decisions where taxpayer claims under "buyer resistance" arguments were rejected. In those cases, the courts found reductions in value related to buyer resistance to be temporary and, therefore, disallowed casualty losses taken with regard to reductions in property values, especially in the absence of significant physical damage. The COVID-19 pandemic brings taxpayers into uncharted territory with regard to casualty losses without physical damage but where there is still an undeniable impact to the business, especially where property values are permanently reduced due to the pandemic. This discussion looks at the jurisprudence with regard to claiming losses where there is no physical loss.
Finkbohner case
In Finkbohner, the taxpayer claimed a casualty loss to his home caused by floodwaters from an adjacent creek that severely damaged several homes in the taxpayer's cul-de-sac but damaged only the taxpayer's grounds and driveway. Even though the property sustained only minor physical damage, the taxpayer successfully argued that its marketability suffered permanent damage due to permanent buyer resistance. After the flood, the local municipality razed the seven significantly damaged homes and purchased the lots, then prohibited reconstruction to keep the lots as permanent open space. The taxpayer argued that this resulted in diminished privacy of his home, as well as increased exposure to crime, and ultimately lowered the home's value. In addition, the assessor for the municipality reduced the local tax assessment on the property after the floods, which further supported the taxpayer's assertion that the property's market value had declined.
Application of Finkbohner
Given the uniqueness of the COVID-19 pandemic, scant guidance exists on the treatment of losses where physical damage is not present with the casualty. Finkbohner may provide support for taxpayers to deduct casualty losses for reductions in value not attributable to physical damage.
Consider an example where a taxpayer closed his retail store and the physical property significantly declined in value as a result of the pandemic. Assume that the taxpayer owns the building, as well as the furniture and fixtures (this example does not address losses related to any decline in the value of inventory). The decline in value is permanent, as the pandemic has significantly accelerated the global market shift from brick-and-mortar stores to e-commerce. (In fact, data from IBM's U.S. retail index suggests the pandemic has accelerated the shift away from physical stores to digital shopping by roughly five years.) In this example, if the taxpayer can demonstrate that the consumer transition to online shopping caused by the pandemic appears to have permanently decreased the value of the physical building, the taxpayer has undoubtedly incurred a loss with regard to the store's fair market value (FMV). But can the taxpayer deduct the reduction in value as a casualty loss under Sec. 165? The following section examines this question in greater detail, including facts and circumstances that may support this position.
Reduction in value as a result of the COVID-19 pandemic
Regs. Sec. 1.165-7 measures a casualty loss as the lesser of the difference in the FMV of the property before and after the disaster or the property's adjusted basis. In the retail example, it appears clear that the FMV of the property has significantly declined. However, under Regs. Sec. 1.165-7, the appraisal of value must recognize the effects of any market decline affecting the property before the casualty. Consequently, if the value of a retailer's store had declined prior to the pandemic (e.g., as a result of general market shifts to e-commerce), that reduction would need to be considered in the appraisal of the store immediately before the pandemic and could not be considered in the calculation of the disaster casualty loss. In this example, if the store had an initial FMV of $150 but the value had been driven down by other factors such that immediately before the pandemic the value was $100 (which was greater than its adjusted basis), then $100 would be the starting point for calculating a casualty loss, not $150.
Permanent versus temporary reductions in value: Most case law involving casualty losses makes clear that reductions in value beyond those caused by physical damage are due to buyer resistance, which is temporary and subsides over time. The concept of buyer resistance being temporary in the case of natural disasters makes intuitive sense, especially since natural disasters impact a finite geographical area. But where does one begin to measure the impact, including the potential application of permanent buyer resistance, of a global pandemic disaster that has affected entire industries such as retail, restaurants, and travel and hospitality?
Future events cannot be considered in determining a current loss: The answer is perhaps best addressed by what a taxpayer cannot consider in evaluating the impact/loss in the context of Sec. 165. The COVID-19 crisis is not the first global pandemic and certainly will not be the last. However, as shown in Kamanski, 477 F.2d 452 (9th Cir. 1973), which is cited and distinguished in Finkbohner, a taxpayer may not consider the impact of future pandemics when evaluating whether a loss related to the COVID-19 pandemic exists. Kamanski involved a California mudslide, which, similar to Finkbohner, resulted in minor damage to the taxpayer's property. The taxpayer recognized a casualty loss for the reduction in value attributable to the existence of dangerous soil conditions that would likely result in additional mudslides. The court found that the loss was due to "buyer predictions that future casualties would cause further damage," concluding that "the claim of loss must await the event."
The court in Finkbohner distinguished its decision from Kamanski by stating: "We note, however, that the 'buyer resistance' in our case is not substantially imputable to any informed fear of future damage." The court made clear that the loss claimed had to be related to the current flood and not a loss in value based on buyer resistance related to fears of potential future floods. In the example involving the retailer, if the retailer's property value reduction is permanent and is due to the COVID-19 pandemic (and not predicated on the occurrence of future pandemics), Finkbohner could apply, and the reduction in value related to permanent buyer resistance may be considered in determining a casualty loss.
Getting over the permanent loss bar: The threshold against a permanent reduction in value may seem a high one to meet, especially considering buyer resistance versus actual physical damage. Finkbohner is useful to taxpayers in this regard. In Finkbohner, as of the date of the trial, the Army Corps of Engineers had planned a project to control the floods, but the funds and project had not yet been approved by the U.S. government or the municipality. While the taxpayer showed evidence that the plan would not positively impact his property (and in fact could be a detriment), it is worth noting that the court did not seem to consider any other potential future mitigation strategies or circumstances in agreeing with the permanence of the decline in market value.
While Finkbohner can provide guidance on a permanent reduction in value, it also shines a spotlight on a taxpayer's need for a robust appraisal of the property and documentation of the permanence of the loss in value. In the above example, the retailer would need an appraisal that supports the current value based on known information and documentation showing why the reduction in value was permanent, which may include documentation relating to the broader impact of the pandemic on retail brick-and-mortar stores.
Changing the example: The example assumes the taxpayer closed his store, but is that a prerequisite to taking a casualty loss? The answer, at least based on Finkbohner, is "no." In Finkbohner, the taxpayer did not abandon his home and continued to live there. The concept of buyer resistance does not require physical damage, abandonment, or physical closure of the property. It can be any reason a buyer has concerns regarding value. In the example, buyer resistance is driven by the impact of the pandemic on brick-and-mortar stores via the acceleration of e-commerce. In Finkbohner, the buyer resistance arose from the empty lots that resulted from the floods.
It is also worth noting that a taxpayer may be able to take a casualty loss even if the taxpayer leases rather than owns property. In this case, the taxpayer would need to evaluate the potential loss related to the leased property, including leasehold improvements.
It's now or never
The court in Finkbohner foresaw a potential whipsaw effect if the taxpayer is not allowed to deduct the current casualty loss. The court reasoned as follows:
Since the loss of value from this and other causes is permanent, there will not be any recovery of it as fears for the future become less acute. A lower value plateau is reached, which will be the "value before" if another catastrophe occurs. Therefore, the owner when the next catastrophe occurs will not be able to claim a casualty loss founded upon it. It must be claimed right now if it is going to be at all. [emphasis added]
Assume the taxpayer in the retail example has a store worth $100 immediately before the pandemic, and the value after the pandemic is permanently reduced to $40 (which is greater than its adjusted basis). If the taxpayer does not claim a casualty loss for the $60 decline in value related to the current pandemic casualty and a fire subsequently destroys the store, the casualty loss would technically be limited to $40 (versus $100). As discussed previously, Regs. Sec. 1.165-7 makes clear that the value immediately before the fire ($40) and the value after ($0) is the amount of loss that can be claimed for the fire casualty.As a result, not deducting the initial casualty loss of $60 from the pandemic would limit the total casualty losses to the $40 attributable to the fire. The other $60 may be deductible under other provisions (e.g., depreciation, abandonment, or loss on ultimate disposition/sale of property), but according to the court in Finkbohner, the time for taxpayers to deduct casualty losses related to the COVID-19 disaster is the year in which the loss is incurred.
An area ripe for further guidance
The COVID-19 pandemic is an unprecedented global disaster that has had a profound and, in some cases, permanent impact on businesses. While the statute and regulations are somewhat clear on casualty losses related to physical damage caused by natural disasters, they are silent with regard to pandemics and a permanent reduction in value not attributable to physical damage. The IRS will need to issue guidance in this area, and various taxpayers, service providers, and other interested parties have already provided their comments (see, e.g., American Bar Association Tax Section, Comments on COVID-19 and Disaster Losses Under Section 165(i) (Sept. 14, 2020), available at www.americanbar.org). Given the current lack of clear guidance, taxpayers may consider Finkbohner in addition to their specific facts and circumstances when evaluating potential casualty loss positions.
EditorNotes
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.
Contributors are members of or associated with BDO USA LLP.
