Casualty loss rules revisited.by Talwar, Akshay K.
By limiting losses to those in excess of 10% of a taxpayer's adjusted gross income (AGI), the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) is alleged to have "simplified" tax compliance for most taxpayers who sustained casualty losses. It did succeed in virtually eliminating all minor deductions for such things as automobile collisions and personal property thefts. As a result, interests in the casualty loss rules waned. The major natural disasters that struck the U.S. in 1989 have rekindled interest. Even before hurricane Hugo and the San Francisco earthquake, property losses from catastrophic incidents approximated $1.7 billion in 1989. Damage from Hugo and San Francisco amount to many billions more.
The amount of a casualty loss for personal use property that may be claimed as a deduction must be reduced by a $ 100 per event floor, followed by a reduction of an aggregate floor of 10% of AGI Sec. 165(c)(3). The $100 floor applies separately to each casualty and to the entire loss from each casualty. The individual adjusted losses are added together, and the total is reduced by 10% of the taxpayer's AGI. The net amount is the taxpayer's itemized deduction for casualty and theft losses.
To qualify as a casualty loss, the loss must be due to a sudden, unexpected, or unusual event or cause. Progressive deterioration inherent in a property is not a casualty. Thus, damage to a home caused by termites does not qualify. There is no casualty loss if it is due to the taxpayer's own negligence or carelessness. However, a casualty loss is considered to have occurred even though the owner was at fault while driving his car, provided the accident was not the result of the owner's willful act or negligence.
Theft losses are deductible in the year discovered rather than the year in which the theft occurs Sec. 165(e). This makes sense because property might be stolen and the theft not discovered in the year it occurred. To avoid what could otherwise be double deduction, a personal casualty loss deducted for estate tax purposes cannot also be claimed for income tax purposes Sec. 165(h)(I)(C).
Also, effective for years beginning after 1986, taxpayers can choose to treat a loss on a deposit for a nonbusiness account in an insolvent financial institution as a personal casualty loss in the year in which the loss amount can be reasonably estimated. This option is in lieu of claiming the loss under the bad debt provisions, which treat such a loss as a short-term capital loss that is deductible only in the year in which there is no prospect for recovery.
Personal Casualty Gains and
Many taxpayers are chagrined to discover that a real economic loss, albeit partially or even fully covered by insurance, results in a taxable gain because insurance proceeds exceed the basis of property lost or destroyed. To determine the amount of gain realized or the loss sustained for property lost, destroyed, or damaged, the taxpayer has to establish and prove the basis of the property. In many cases, this is easier said than done, Few taxpayers keep records of purchases of personal property. Furthermore, the property stolen is sometimes acquired through gift. Consequently, the taxpayer's basis is often a substituted basis. In case of theft, the fair market value (FMV) of the property stolen is deemed to be zero after the theft loss.
However, if property is merely damaged, as, for example, in a fire or flood, the taxpayer's loss is limited to the lesser of:
* The difference between the FMV before and after the casualty; or
* The taxpayer's basis in the property damages as a result of the casualty.
For example, Henry's car is damaged in an accident. He bought the car five years ago for $10,000 for personal use. The FMV of the car was $3,500, according to the "Blue Book," immediately before the accident and $300 immediately thereafter. The damage to the car was not insured. Henry had the car repaired at a cost of $4000. Henry's AGI was $25,000.
Before taking into account the per loss $100 floor, Henry's casualty loss is the lesser of:
* The diminution in the car's FMV $3,200 ($3,500 - $3,00); or
* The basis of the car, or in this case $10,000.
Therefore, Henry's casualty loss deduction is $3,100, the $3,200 diminution in FMV, less the $100 floor. However, if this is Henry's only casualty loss, the amount that will reduce taxable income is only $600, since the $3,100 casualty loss must be reduced by $2,500, 10% of Henry's $25,000 AGI.
If an insurance carrier reimbursed Henry for the repairs to his car, he would recognize neither gain or loss. The amount received from the carrier is not taxable in his hands.
The basic rule for casualty losses sustained in tax years beginning after 1986, state that a taxpayer will not be permitted to deduct a casualty loss for damage to insured property that is not used in a trade or business or in a transaction entered into for profit, unless a timely insurance claim is filed with respect to the damage to the property. This rule applies to insurance coverage that provides for full or partial reimbursement for the loss. If the loss is covered by insurance, it is irrelevant whether the taxpayer is the primary beneficiary of the policy so long as the filing of the claim is within the taxpayer's control.
If a taxpayer insures personal property, the insurance premiums paid are nondeductible personal expenses (Sec. 262). However, insurance proceeds can lead to realization of gain, which may or may not result in recognition of gain for income tax purposes. For example, Ivan acquired a painting from his father's estate in 1988. The FMV of the painting was included in his father's estate at $1,000 which became his basis for the painting. In 1988, the painting was valued at $5,000 and insured for $5,000. In 1989, the painting was stolen, and the theft reported to the police. Ivan filed a claim with the insurer in 1989 and was paid $5,000 in 1990. Even though the loss occurred in 1989, Ivan cannot claim a loss in that year because the loss was insured. In 1990, Ivan has a long-term capital gain of $4,000--the difference between the $5,000 insurance proceeds reduced by his $1,000 basis in the painting. Ivan can avoid recognition of all or part of the $4,000 capital gain if he uses all or part of the insurance proceeds to replace the painting.
Federal Disaster Area
If damaged property is located in an area designated by the President to be a Federal Disaster Area (e.g., Charleston and San Francisco), taxpayers may choose to deduct losses in the tax year the losses occurred or in the prior year Sec. 165(i). This allows taxpayers to speed up tax refunds. Thus, taxpayers affected by Hugo or the San Francisco earthquake can elect to amend their 1988 returns and file for an immediate refund instead of waiting to file their 1989 returns.
Planning Pointer: Because personal casualty losses are reduced by $100 per loss with the remaining loss deductible to the extent it exceeds 10% of AGI, it usually would be advisable to choose the year with the lower AGI to take the deduction. However, because of graduated rates, calculations should be made for both years to see the most beneficial result. Also, marital status may be important. If the destroyed property is owned separately, that spouse might claim the entire loss on a separate return basis. In that case, the loss would be reduced only by 10% of the spouse's AGI.
The election must be made either by the unextended due date of the return for the year in which the casualty loss occurred or, if later, the extended due date of the return for the preceding tax year. After making the election, a taxpayer has 90 days to revoke it and return any refund received because of the election. If the taxpayer receives the refund after revoking the election, the refund must be returned within 30 days of receipt.
Prior law allowed casualty loss deductions only for sudden, unexpected losses. Accordingly, taxpayers whose residences had physically been destroyed in a disaster were allowed deductions. However, taxpayers whose residences had been condemned because of a threat of further destruction or were deemed to be unsafe were denied similar deductions. Congress felt that this result was inequitable and, as a part of TRA 84, effective for tax years ending after 1981, enacted Sec. 165(k). Under this statute, a taxpayer whose residence is located in a disaster area may deduct as an itemized casualty loss deduction "any loss" attributable to the disaster.
The requirements for deductibility of such a loss include:
* The taxpayer must be ordered, by the state or local government of the state in which the residence is located, to demolish or relocate the residence.
* The order must be made no later than the 120th day after the President's determination that the area warrants federal disaster assistance; and
* The residence must have been rendered unsafe for use as a residence by reason of the disaster.
The election to deduct a disaster loss for the year before the year in which it occurs is made by filing either a return, an amended return, or a refund claim. Thus, the election may be made even though the taxpayer filed his or her return before the loss occurred Reg. Sec.1.165-11(e). The election must be in writing and signed by the taxpayer. In general, the return or claim should specify the date or dates of the disaster that caused the loss, and the city, town, county, state where the property was located at the time of the disaster. The return, amended return, or refund claim must clearly show the election made. As the case with other types of casualty losses in a Federal Disaster Area, this election has to be made on or before the later of:
* The regular due date for the tax return (without regard to extensions) for the taxable year in which the disaster actually occurred; or
* The due date for the return for the previous year with permitted extensions taken into account.
Taxpayers are given 90 days in which to change their minds after making an election. The election becomes irrevocable only after 90 days following the date the election was made.
Insurance Proceeds Used to
Replace Lost or Damaged
Ordinarily, a gain is realized when a taxpayer receives insurance proceeds with respect to a casualty if the insurance proceeds exceed basis. This occurs frequently because property would normally be insured for its FMV, which often exceeds basis. Sec. 1033 provides for nonrecognition of gain if there is a timely replacement of the property involuntarily converted to the extent that the insurance proceeds are reinvested in property that is similar or related in service or use to the property involuntarily converted. Property lost, damaged or destroyed is deemed to be involuntarily converted if, as a result of insurance, the taxpayer received insurance proceeds with respect to the property.
Sec. 1033(a)(1) provides that no gain is recognized if the insurer satisfies the claim of the taxpayer by replacing the property. However, the replacement property received must be similar or related in service or use to the property involuntarily converted. In this situation, nonrecognition of gain is mandatory. Needless to say, the basis of the replacement property is the same as the basis of the property lost, damaged, or destroyed.
Generally, insurance claims are satisfied by cash settlements rather than by replacement of the property involuntarily converted. If the claim is satisfied by a cash settlement, the insured taxpayer is not required to replace the property involuntarily converted, but may elect to do so. Consequently, on receipt of a cash settlement, the insured realizes a gain to the extent that the cash settlement exceeds his or her basis of the property involuntarily converted. What is more, under Sec. 1033(a)(2), the gain thus realized is recognized unless the taxpayer elects not to recognize his or her gain, or part thereof, and uses the insurance proceeds to acquire "similar or related" property. The "similar or related" property must be acquired within two years after the close of the taxable year in which any part of the gain was realized. The two-year replacement period can be extended by the IRS if the taxpayer can show reasonable cause for not being able to replace the property involuntarily converted within the two-year period. In the case of real estate, the replacement period is three years Reg.Sec.1.1003(a)-2(c)(3).
If real estate is involuntarily converted as, for example, by fire, the replacement can be in the form of purchasing a controlling interest (80% of the total voting power and 80% of the total of all other shares) in a corporation owning "similar or related" replacement property Sec. 1033(a)(2)(A) and (E).
Basis of "Similar or Related"
Property When Gain is
If taxpayers properly elect not to recognize gain from the involuntary conversion of property, the basis of the replacement property is the cost thereof reduced by the gain not recognized Sec. 1033(b). For example, Ramona's apartment house is completely destroyed by fire. Her adjusted basis for the building and land was $50,000, the FMV for the building was $240,000, and that of the land $10,000. She had the building demolished at a cost of $30,000 and then sold the land for $10,000. The insurance proceeds were $270,000 representing:
FMV of building before the fire $240,000 Plus: Cost of demolition 30,000 Insurance proceeds $270,000
Within 17 months of the fire, she purchased all the stock of a corporation for $180,000, with a $30,000 down payment and the balance of $150,000 secured by the pledge of the stock. The main asset of the corporation was an apartment house. Assuming Ramona elects not to recognize gain under Sec. 1033 (a)(2), what gain, if any, is recognized and what is the basis for her shares in the corporation she purchased for $180,000? See Figure 1.
If a taxpayer sustains a casualty loss which will result in a realized gain because the insurance proceeds exceed basis, he or she may be faced with a compliance problem. Gain realized must be recognized unless there is timely and adequate reinvestment in "like-kind" property of the insurance proceeds.
The taxpayer must include in the return for the year in which the involuntary conversion (casualty loss) occurred all of the data in connection with the casualty loss. This would include information concerning the intent to reinvest the insurance proceeds in "like-kind" property.
The election to defer recognition of gain is made by including in gross income only so much of the gain as is taxable. In other words, if the realized gain on receipt of $100 insurance proceeds is $30 and the actual or anticipated cost of qualified replacement property is only $80, the taxpayer should report a $20 gain. If the actual replacement cost is not what it was anticipated to be (or if no timely or no qualified replacement is made), an amended return would have to be filed Reg. Sec. 1.1033(a)2(c)(2).
The failure to include gain in gross income is deemed to be an election to defer recognition. To permit proper administration of the tax laws, the statute of limitations for assessing a deficiency attributable to any part of the gain realized from an involuntary conversion does not expire until three years after the date on which the IRS is notified that:
* There has been a timely replacement of qualified "like-kind" property and the amount thereof; or
* The taxpayer has abandoned the intention to acquire qualified "similar related" replacement property; or
* The taxpayer has failed to acquire qualified "like-kind" property within the required period.
Interplay of the Casualty and
Passive Loss Rules
TRA 86 enacted passive activity loss rules to defer deductions until final disposition of the activity. Congress enacted these rules because it believed that economic gain or loss on a passive investment cannot be accurately measured until disposition.
Many taxpayers in California and the Carolinas suffered losses eligible for current deduction under casualty loss rules. However, if the property destroyed or damaged was rental property, the loss would automatically be considered passive. Under current law, even though a loss on rental property is eligible for deduction under the casualty loss rules, it will be suspended under the passive loss rules.
This result is not equitable. With a casualty, the taxpayer suffers a true, measurable economic loss which the taxpayer should not be required to defer. The AICPA feels that a current deduction should be allowed in the year that the casualty occurs and is currently lobbying for legislative or administrative action to rectify the inequity presented by current law (see Wall Street Journal, November 6, 1989, Tax Report). At this writing, no action had been taken either administratively or by the Congress regarding this problem.
Alternative Minimum Tax
It should be noted that for purposes of the AMT, casualty or theft loss deductions are allowed to the extent allowed for the regular tax.
Special Relief for Victims of
Hurricane Hugo and the San
In Notices 89-107, 89-108 and 89-136, the IRS has extended return filing deadlines for taxpayers who were affected by Hurricane Hugo and the San Francisco earthquake.
Under Notice 89-136, taxpayers who received six-month filing extensions for 1988, but who could not meet the October 1989 deadline because of the hurricane, will be deemed to have reasonable cause for late filing. No Sec. 6651(a)(1) penalty will be imposed if they write "HUGO" on their returns and those returns are post-marked by January 16, 1990. Also, no Sec. 6651(a)(2) penalty will be imposed with respect to those returns accompanied by payment of the reported tax due if the amount due is 10% or less of the tax liability shown on the return. Abatement of penalties on returns filed after that date will be considered on a case-by-case basis. Interest, which by law may not be abated, will be due at the underpayment rate on any unpaid taxes from the original due date of the return to the date of payment.
Relief was also provided for elections that must be made on timely filed returns, filing of tax returns by fiscal year taxpayers, filing of excise, employment tax, estate tax, and pension and employee benefit plan returns (and related excise taxes) and failure to make payment of other federal taxes (Notice 89-107). Similar rules for the San Francisco quake victims are covered in Notice 89-108.
Recently, tax practitioners rarely encountered the casualty loss deduction. 1989 has been a banner year for catastrophic disasters across the U.S. forcing tax practitioners to reacquaint themselves with these rules. Perhaps the future will bring better days and these rules will return to relative obscurity.
Akshay K. Talwar, JD, MS, LLM (Taxation), CPA, is an Associate Professor of Accounting at Baruch College, and an attorney-at-law in the field of taxation. He is the author of numerous professional publications, including AICPA professional education programs and articles in professional periodicals. Mr. Talwar is Tax Technical Editor for The CPA Journal and Chairman of the Tax Education Committee of the NYSSCPA.
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