Middle Tennessee has been hard-hit with a variety of weather-related disasters in recent months, from Nashville’s late-night tornado in March 2020 to the flooding that overwhelmed several counties this year. In other parts of the U.S., hurricanes and wildfires have been devastating.
Every year, natural disasters lead to significant losses and leave millions of taxpayers vulnerable. If you’re among them, you could qualify for a federal income tax deduction as well as other relief from the IRS.
Eligibility for the casualty loss deduction
Casualty losses can result from the damage, destruction, or loss of property due to any unexpected or unusual event. Examples include floods, hurricanes, tornadoes, fires, earthquakes, and volcanic eruptions. Normal wear and tear or progressive deterioration of property doesn’t constitute a deductible casualty loss. For example, drought generally doesn’t qualify.
Tax deductions vary depending on whether the casualty losses relate to personal-use or business-use items. For the most part, losses related to your home, household items, and personal vehicles can be deducted if they occur in a federally declared disaster area — that’s the designation for a state or county that the president declares eligible for federal assistance. Casualty losses related to business or income-producing property (for example, rental property) can be deducted regardless of whether they occur in a federal disaster area.
Casualty losses are deductible in the year of the loss, usually the year of the casualty event. If your loss stemmed from a federally declared disaster, you can treat it as though it occurred in the previous year. You could receive your refund more quickly if you amend the previous year’s return rather than wait until you file your return for the casualty year.
The role of reimbursements
If your casualty loss is covered by insurance, you must reduce the loss by the amount of any reimbursement or expected reimbursement. You also must reduce the loss by any salvage value. Reimbursement also could lead to capital gains tax liability.
When the amount you receive from insurance or other reimbursements (less any expense you incurred to obtain reimbursement, such as the cost of an appraisal) exceeds the cost or adjusted basis of the property, that qualifies as a capital gain. You’ll need to include that gain as income unless you’re eligible to postpone reporting the gain.
You might be able to postpone the reporting obligation if you purchase property that’s similar in its service or use to the destroyed property within the specified replacement period. You also can postpone if you buy at least 80% interest in a corporation owning similar property or if you spend the reimbursement to restore the property.
Alternatively, you can offset casualty gains with casualty losses not attributable to a federally declared disaster. This is the only way to deduct personal-use property casualty losses incurred in areas not declared disaster areas.
Loss amount versus deduction
For personal-use property, or business-use or income-producing property that isn’t destroyed, your casualty loss is the lesser of:
- the adjusted basis of the property immediately before the loss (generally, your original cost, plus improvements and less depreciation), or
- the drop in fair market value (FMV) of the property because of the casualty — in other words, the difference between the FMV immediately before and immediately after the casualty.
For business-use or income-producing property that’s destroyed, the amount of the loss is the adjusted basis less any salvage value and reimbursements.
If a single casualty involves more than one piece of property, you must figure the loss on each separately, then combine these losses to determine the casualty loss.
An exception applies to personal-use real property, such as a home. The entire property (including improvements such as landscaping) is treated as one item. The loss is the smaller of the decline in FMV of the entire property and the entire property’s adjusted basis.
Other limits may apply to the amount of the loss you may deduct, too. For personal-use property, you must reduce each casualty loss by $100, but that’s after you’ve subtracted any salvage value and reimbursement.
If you suffer more than one casualty loss during the tax year, you must reduce each loss by $100 and report each on a separate IRS form. If two or more taxpayers have losses from the same casualty, the $100 rule applies separately to each taxpayer.
But that’s not all. For personal-use property, you also must reduce your total casualty losses by 10% of your adjusted gross income, after you’ve applied the $100 rule. As a result, smaller personal-use casualty losses often provide little or no tax benefit.
Which records are required
Documentation is critical to claim a casualty loss deduction. You’ll need to be able to show:
- that you were the owner of the property or, if you leased it, that you were contractually liable to the owner for the damage,
- the type of casualty and when it occurred,
- that the loss was a direct result of the casualty, and
- whether a claim for reimbursement with a reasonable expectation of recovery exists.
You also must be able to establish your adjusted basis, reimbursements, and, for personal-use property, pre-casualty and post-casualty FMVs.
The IRS has granted tax relief this year to victims of natural disasters in several states, including Tennessee. Other states are Alabama, California, Kentucky, Louisiana, Michigan, Mississippi, New Jersey, New York, Oklahoma, Pennsylvania, and Texas. In most cases, the relief extends filing and other deadlines. The IRS provides state-by-state information for disaster relief at https://bit.ly/3nzF2ui.
Keep in mind that you can be an affected taxpayer even if you don’t live in a federally declared disaster area. You’re considered affected if the records you need to meet a filing or payment deadline are located in a covered disaster area. For example, if you don’t live in a disaster area, but your tax preparer does and is unable to pay or file on your behalf, you likely qualify for filing and payment relief.
A team effort
If you’ve incurred casualty losses this year, we can help you explore potential tax relief and other options that could save you money. Reach out to me or any member of our tax services team.
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