The Tax Implications of Disaster
By Christopher R. Cicalese, CPA, Alloy, Silverstein, Shapiro, Adams, Mulford, Cicalese, Wilson & Company –
June 5, 2017
The dismay that a disaster leaves behind often prevents those affected from thinking about the tax implications that recovery may entail. Disasters, whether a historic storm or an unintentional fire, can bring all sorts of tax situations into play. In some instances, it is too complicated for taxpayers to ultimately decide how to correctly handle the specific circumstances.
As such, it is important for CPAs, as trusted advisors, to educate themselves and their clients about the basic tax implications of any disaster.
A casualty loss occurs when property is damaged, destroyed or lost from any unexpected, unusual or sudden event, not including normal wear and tear. Casualty losses are often associated with headline disasters such as Superstorm Sandy. However, a casualty loss can also result from a simple basement leak from a typical thunderstorm. The tax treatment of these different types of losses is intricate.
To deduct a casualty loss, one must be able to support the amount taken as a deduction and show that there was a casualty. Typically, a taxpayer should be able to show the type of casualty and when it occurred, that the loss was a direct result of a casualty, that the person was the rightful property owner or contractually liable to the owner for damaged lease property, and whether a claim for reimbursement exists that has a recovery expectation.
If the property was for personal use or was not completely destroyed, the amount of the loss would be the lesser of the adjusted basis of the property or the decrease in the fair market value (FMV) as a result of the casualty. Real property for personal use should include any improvements as one entire property, such as buildings and landscaping, for determining the FMV decrease and adjusted basis. Business property or income-producing property does not take the FMV decrease into consideration and calculates the loss as adjusted basis in property, less salvage value, less insurance or other reimbursement received or expected to be received. For a business that lost inventory, including items held for customer sale, there are two options to deduct the loss. The first is by reporting the casualty as a cost of goods sold through the opening and closing inventory balances. If this method is used, the casualty loss should not be claimed again on the return, and any type of reimbursement should be included in gross income. An inventory loss can also be deducted separately by adjusting opening inventory or purchases for the effected inventory items. Unlike the previous method, reimbursements would not be included in gross income and instead should reduce the loss. A loss cannot be claimed to the extent that there is a reasonable prospect of recovery if a reimbursement is not received by the end of the year.
The deduction for casualty losses is limited for employee and personal- use property. Business and income-producing property are typically not subject to deduction limits, but in some cases the loss will be limited. For employee property, which is property used in performing services as an employee, a loss is subject to the 2-percent rule. This rule reduces the casualty loss, along with job expenses or miscellaneous itemized deductions, by 2 percent of adjusted gross income (AGI).
Personal-use property is subject to the $100 and 10-percent rule. Under the $100 rule, the loss is reduced by $100, regardless of how much property is involved; however, if a taxpayer has multiple casualty losses during the year they are considered separate. After reducing each loss by the $100 rule, the losses are then reduced by 10 percent of AGI.
Insurance and Other Reimbursements
The most common form of reimbursement for a casualty loss is insurance payments. In order to deduct a casualty loss, a timely insurance claim must be filed for reimbursement if the property is insured. The expected reimbursement must be subtracted when figuring the loss, even if the payment will not be received until a year later. If the actual reimbursement is more or less than what was expected, the amount must be adjusted on the tax return for the tax year in which the payment was received. Employer emergency disaster funds should also be considered when computing the casualty loss deduction in that only the amount used to replace destroyed or damaged property should be considered for reducing any unreimbursed losses. Cash gifts that are excludable from income and carry no restrictions on their use do not reduce the casualty loss amount.
If insurance payments were received to specifically cover living expenses and there was a temporary increase in living expenses, the excess is reported as income unless the casualty occurs in a federally declared disaster area. In such an area, the qualified disaster relief payment would not be included in income to the extent that any expenses compensated by these payments are not otherwise compensated for by any other insurance or reimbursement. The payment would be tax free as long as it is for reasonable and necessary personal or family expenses, repairs or rehabilitation of a personal residence, or repair or replacement of contents of a personal residence. If part of the payment is to be included in income, it would be included in the year the person regains use of his or her main home or, if later, the year he or she receives the taxable portion of the insurance payment. A grant that a business receives under a state program for losses incurred is not excludable from income. However, a business can postpone the gain if the owner buys qualifying replacement property within a certain time period.
The road to recovery after a disaster can be overwhelming. By helping clients understand the tax implications, a CPA not only eases the client’s mind, but also makes the trusted advisor relationship stronger.