This Tax Alert addresses the federal income tax treatment of casualty losses on personal-use property (i.e., property not used in a trade or business or for the production of income). Specifically, this Tax Alert addresses the following casualty loss topics:
- What is a casualty?
- Proof of loss
- Amount of loss
- Decrease in fair market value
- Deduction limits
- How to report a casualty loss
What is a Casualty?
A casualty is the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual. Deductible casualty losses can result from a number of different causes, including floods, hurricanes, and tornadoes.
Proof of Loss
To deduct a casualty loss, the taxpayer must be able to (1) show that there was a casualty, and (2) support the amount claimed as a deduction. Thus, a taxpayer claiming a casualty loss should be able to prove all of the following:
- The type of casualty (e.g., flood, hurricane, etc.)
- That the loss was a direct result of the casualty
- That he or she was the owner of the damaged property, or if he or she leased the property from someone else, that he or she was contractually liable to the owner for the damage
- Whether a claim for reimbursement exists for which there is a reasonable expectation of recovery
Amount of loss
The amount of a personal-use property casualty loss is computed as follows:
- Determine the adjusted basis in the property before the casualty
- Determine the decrease in the fair market value (FMV) of the property as a result of the casualty
- Subtract from the smaller of the amounts determined in (1) and (2) any insurance or other reimbursement received or expected to be received
In other words, the amount of personal-use property casualty loss is the smaller of the taxpayer’s adjusted basis in the property or the decrease in the FMV of the property as a result of the casualty, less any insurance or other reimbursement received or expected to be received.
Example 1: B purchases an automobile (which she uses for nonbusiness purposes) for $30,000 in 2015. In 2017, the automobile is damaged in a flood. The FMV of B’s automobile is $18,000 immediately before the flood and $1,000 immediately after the flood. B receives insurance proceeds of $10,000 to cover the loss. The amount of B’s casualty loss for 2017 is $7,000, computed as follows:
- Lesser of B’s adjusted basis ($30,000) or decrease in FMV ($17,000) - $17,000
- Less: Insurance received - (10,000)
- Casualty loss - $ 7,000
See, however, the discussion of deduction limits below.
If a single casualty involves more than one item of property, the loss on each item of property generally must be computed separately, and then the separate losses are combined to determine the total loss from that casualty. However, there is an exception for personal-use real property (e.g., a personal residence) – in the case of personal-use real property, the entire property (including improvements such as buildings, trees, and shrubs) is treated as one item. Thus, a casualty loss involving personal-use real property is determined by using the lesser of the adjusted basis in the entire property or the decrease in the FMV of the entire property.
Example 2: A purchases land and a house (which A uses as his primary residence) in 2009 for $500,000. Subsequently, A spends $10,000 to plant trees on the grounds surrounding the house. In 2017, the land, house, and trees are damaged by a flood. At the time of the flood, the adjusted basis of the land is $125,000, the adjusted basis of the house is $375,000, and the adjusted basis of the trees is $10,000. The FMV of the land and house immediately before the flood is $150,000 and $450,000, respectively, and immediately after the flood is $75,000 and $225,000, respectively. The FMV of the trees immediately before the flood is $12,000 and immediately after the flood is $5,000. A receives $100,000 of insurance for damage to the house. The amount of A’s casualty loss for 2017 is $207,000, determined as follows:
- Lesser of A’s total adjusted basis ($510,000) or total decrease in FMV ($307,000) - $307,000
- Less: Insurance received - (100,000)
- Casualty loss - $207,000
See, however, the discussion of deduction limits below.
Decrease in Fair Market Value
Fair market value is the price upon which a willing buyer and willing seller, each under no compulsion to buy or sell and both with knowledge of all relevant facts, would agree to buy or sell the subject property. An appraisal prepared by a competent appraiser is generally required to determine the decrease in FMV of property caused by a casualty.
However, the cost of repairing damaged property can be used as a measure of the decrease in FMV if all of the following conditions are satisfied:
- The repairs are actually made
- The repairs are necessary to bring the property back to its condition before the casualty
- The amount spent for the repairs isn’t excessive
- The repairs take care of the damage only
- The value of the property after the repairs is not, due to the repairs, more than the value of the property before the casualty
In any event, the following items may not be considered when determining the decrease in the FMV of property caused by a casualty:
- The incidental expenses due to a casualty, such as expenses for the treatment of personal injuries, for temporary housing, or for a rental car
- The cost of replacing destroyed property
- Sentimental value
- A decrease in the value of the property because it is in or near an area that suffered a casualty
- The costs of photographs and appraisals used as evidence of the value and condition of property damaged because of a casualty (but these costs can be claimed as a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income limit on Schedule A [Form 1040])
The deduction for a casualty loss on personal-use property is limited. Specifically, a $100 reduction and a 10% of adjusted gross income (AGI) reduction apply.
A casualty loss on personal-use property is first reduced by $100. This reduction applies to the total casualty loss associated with a single event – it does not matter how many pieces of property are involved in that event. If, however, there are multiple events in one year that generate multiple casualty losses, the $100 reduction applies to each of the multiple casualty losses.
10% of AGI Reduction
A casualty loss on personal-use property is then reduced by 10% of the taxpayer’s AGI for the year the loss is claimed. This reduction applies to the total casualty loss claimed during a particular year – it does not matter how many pieces of property are involved or how many events generated the total loss during that year.
Example 3: Assume the same facts as Example 2, and that A’s AGI for 2017 is $250,000. The amount of A’s deductible casualty loss is $181,900, determined as follows:
- Casualty loss - $207,000
- Less: $100 reduction - (100)
- Less: 10% AGI reduction - (25,000)
- Deductible casualty loss - $181,900
How to Report a Casualty Loss
A casualty loss on personal-use property is reported on Forms 4684 and Schedule A of the taxpayer’s Form 1040. Although a casualty loss on personal-use property is treated as an itemized deduction, it is not subject to the phase out rule (the Pease limitation) that applies to other itemized deductions claimed by high-income taxpayers.
A casualty loss generally must be claimed for the year it occurred. However, a casualty loss generated by a federally declared disaster (an “eligible” casualty loss) can be claimed for the year it occurred or for the immediately preceding year. If a taxpayer wants to claim an eligible casualty loss for the immediately preceding year, he or she must do so – typically by filing an amended return for that year – on or before the date that is six months after the original due date (without extensions) for filing the taxpayer’s tax return for the year the loss actually occurred. For example, if an individual incurs an eligible casualty loss in 2017, he or she has until October 15, 2018 (six months after the original due date of the individual’s 2017 tax return) to elect to claim the loss on his or her 2016 tax return (by filing an amended return for 2016).
If a taxpayer wishes to elect to deduct an eligible casualty loss for the immediately preceding tax year, he or she should include a statement on his or her return (or amended return) for that year that indicates that a Section 165(i) election is being made and that includes the following information:
- The name or a description of the disaster giving rise to the loss
- The date or dates of the disaster
- The city, town, county or parish, state, and ZIP code where the damaged or destroyed property was located at the time of the disaster
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