Casualty Loss Rules Differ for Personal and Business Property
If you've suffered from a theft, accident, fire, flood, or some other casualty during the year, you may be able to deduct some of your unreimbursed losses. The amount depends upon whether the property was personal or business, and upon the amount of your reimbursement.
Casualty losses are treated differently depending on whether the loss occurred to property used in your trade or business, to generate investment income, or for personal or family purposes. However, regardless of the type of property, the loss must first be reported on IRS Form 4684, Casualties and Thefts. For that reason we're going to discuss all types of casualties, both business and personal, in the following section.
What is a Casualty?
A casualty, for federal income tax purposes, is a sudden, unexpected, or unusual loss or damage to some property you own.
Examples of events that typically cause casualty losses are earthquakes, hurricanes, tornadoes, floods, storms, volcanic eruptions, shipwrecks, cave-ins, sonic booms, fires, car accidents, airplane crashes, riots, vandalism, or burglaries, larcenies, or embezzlement.
Examples of events that are not considered deductible casualties are progressive deterioration caused by age, wind and weather, wood rot, termites or other insect infestation, or drought.
There are rare situations where insect infestation can be considered a casualty for tax purposes, if the destruction was very sudden and severe. Also, drought can be considered a casualty if the property was used for a trade or business or in some other transaction entered into for profit, such as an investment in farmland.
Simply misplacing or losing property does not qualify as a tax-deductible casualty, even though your insurance company may consider it a reimbursable loss. However, if you lose property in conjunction with another accident, it may qualify. For instance, if you were involved in a car accident that scattered your property into the surrounding area and some of your jewelry was never found, you may be able to deduct the loss of the jewelry.
Losses of business inventory can be treated as either a casualty loss, or as part of your cost of goods sold. Treating this kind of loss as part of your cost of goods sold will generally mean that you'll have less net income from your business, which, depending on your income level, may save you some Self-Employment Contributions Act (SECA) tax.
Losses in federally declared disaster areas. If you suffered a casualty loss in an area that was declared a federal disaster area by the President, you can claim your casualty loss deduction retroactively, by treating the loss as if it occurred in the previous year and filing an amended tax return for that year. This allows you to receive a quick tax refund - money that you can use right away.
Measuring a Casualty Loss
For income tax purposes, only losses to property are deductible as a casualty loss. You can't deduct the loss of future earnings if your business is damaged in a fire, nor can you deduct the loss of time you spent cleaning up after the fire. For personal losses, you can't deduct the extra living expenses you may have such as renting a car after your personal automobile was damaged in an accident.
How do you measure the amount of damage to your property? The IRS measures a casualty loss using a rather conservative yardstick.
You must use the lesser of either:
- the property's adjusted tax basis immediately before the loss, or
- the property's decline in fair market value due to the casualty.
IRS Form 4684, Casualties and Thefts requires you to compare these two figures and will only allow you to deduct whichever is lower.
This means that if your property has increased in value since you purchased it, you're out of luck: you can only deduct the property's cost. However, if your property has decreased in value, your loss is limited to the lower current value.
What if the property was totally destroyed? If the property was totally destroyed in a casualty, rather than just damaged, the value of the loss depends on whether the property was business or personal-use property. If it was used for personal purposes, the rule stated above for damaged property still holds.
If the destroyed property was used in a business or to produce income, you must use the property's adjusted tax basis after the loss, minus any salvage value. For business property, the fair market value does not come into play at all.
Fact and Amount of Loss Must Be Proven
In order to claim a casualty loss deduction, you must be prepared to prove not only that you lost property in a casualty, but the amount of your loss. This requires knowing your basis in the property, its pre- and post-casualty value and the amount of reimbursement you received.
What is adjusted basis? Your adjusted tax basis for property generally is equal to the costs of acquiring it, plus the cost of any improvements, and minus any depreciation deductions or previous casualty losses.
You purchased a table at an auction for $100. Later you discovered that the table was actually an antique and its fair market value was $1,000. If the table was destroyed in a fire, your loss would be limited to the $100 you paid for it.
What if the casualty affected multiple items? If a single casualty or theft involves more than one piece of property, you must calculate the value of the loss separately for each item.
There's an exception to this rule if the loss was to your home or other personal-use real estate: in that case, you can treat the entire property as a single item (including all buildings, improvements, trees and landscaping). But generally, each item will be listed in a separate column on the appropriate section of your IRS Form 4684.
Be Prepared to Prove the Loss
You had some of your property destroyed as result of a sudden, unexpected event--a casualty. Now, you want to claim a deduction for the loss.
In order to determine the amount of your deduction loss, you must determine (and document) all of the following information:
- that you owned the property
- the amount of your basis in the property
- the pre-disaster value of the asset
- the reduction in value caused by the disaster
- the lack or insufficiency of reimbursement to cover the costs
You must bear the risk of loss to claim the loss. To claim a casualty loss deduction, you generally must be the owner, or co-owner, of the property. If more than one person owns the property, the loss must be allocated among the owners in proportion to their ownership interests. Therefore, you can't claim a loss for the destruction of property owned by your manager or employee or landlord. However, if the risk of loss was shifted to you by a contract, you can claim a deduction even if you didn't own the property.
If the rental agreement for your office space says that you must pay for any damages to the building resulting from a casualty, then you are entitled to claim a loss deduction for the damages.
Be prepared to prove your basis. Proving the basis of business property is generally not a problem. As a business owner, you should have adequate records of the property's original cost or other basis, plus any additions or subtractions to the basis, for tax and accounting purposes.
For personal property, proving the basis may be more difficult. For larger items such as your home, you should have retained the sales contract or closing documents in your safe-deposit box. However, for furniture, cars, clothing, household items etc., it's quite impractical to save every sales slip. In the case of most household items, the fair market value at the time of their loss will be less than the purchase price, due to wear-and-tear, so proving your basis in the property will likely be unnecessary.
Casualty Loss Reimbursement Could Trigger Gain
If your property loss was covered by insurance, you must submit a timely claim for reimbursement in order to deduct any casualty losses. If you receive insurance reimbursement that is more than your adjusted basis in the destroyed or damaged property, you may actually have a gain as a result of the casualty or theft. You may be able to avoid immediate taxation on the gain by purchasing replacement property.
Reimbursement pending when return is due. If, at the time your tax return is due, you haven't yet received the final word from your insurance company on what your reimbursement will be, you must take a stab at an approximation, and subtract that amount. If it later turns out that you receive less than you expected, you can deduct the difference as a casualty loss on the tax return for the later year in which the insurance claim is finalized.
If it turns out that you receive more than you expected, you will have to include the excess amount in income in the year you receive it. However, if any part of your original deduction did not reduce your tax bill, you don't have to include that part of the reimbursement in your income.
In December of 2013, you suffered a personal loss of $5,000 and expected to receive $3,000 from your insurance company. However, due to the application of the $100-plus-10 percent rule, you were unable to deduct any of your loss in 2013. If, in 2014, you actually receive $5,000 from the insurance company, you don't have to declare any of it as income. This results because you didn't deduct any loss in 2013, and the insurance payment does not exceed the actual amount of the loss.
Reimbursement Greater than Basis Triggers Casualty Gain
If the amount you receive as reimbursement exceeds the amount of your adjusted basis in the property, you may have a gain, rather than a loss. However, the fact that a gain exists does not necessarily mean that it will be taxable right away. You will probably be able to defer the gain to a later year (or perhaps indefinitely) if you purchase qualified replacement property.
First, in calculating your gain, remember that you can subtract from your reimbursement any expenses you incurred in obtaining the reimbursement, such as the expenses of hiring an independent insurance adjuster.
Then, if you spend the same amount as the remainder of the insurance money you received, either repairing or restoring the property, or in purchasing replacement property, you can postpone tax on the gain. However, you must make the replacement within two years of the end of the tax year in which you have the gain. (If the loss was to your main home, and the area was declared a federal disaster area, you have more time: up to four years after the end of your tax year in which you have the gain.)
The replacement property must be similar or related in use to the property that was destroyed. For instance, if your car was destroyed, you can replace it with another car, but not with a piano. If your home was destroyed, you can replace it with another main residence such as a home or a condo, but not with a store building. If the property was investment real estate, then other investment real estate will qualify as a replacement, but not a second home. However, if the property was business or income-producing property located in a federally-declared disaster area, any business-use property will qualify.
You cannot postpone a casualty gain of more than $100,000 by purchasing replacement property from a related party, such as a corporation you control. However, you can replace property and defer gain by purchasing a controlling interest in a corporation that owns similar property, as long as you own at least 80 percent of the stock. If you purchase replacement property, you will have to reduce the tax basis of the new property to reflect the casualty gain you postponed.
If you receive insurance reimbursement that is more than your adjusted basis in the destroyed or damaged property, you may actually have a gain as a result of the casualty or theft. You may be able to avoid immediate taxation on the gain by purchasing replacement property.
The following example illustrates the interplay of the casualty loss deduction rules and insurance reimbursement.
Daisy Tandy, an avid car collector, purchased a 1948 Packard convertible in poor condition at a garage sale for $1,000. After months of hard work and an additional $5,000 in car parts, she managed to restore most of the car's majesty, not to mention its chrome. To protect her labor of love and her investment, she insured the car for $25,000, with a $500 deductible.
After a freak auto accident involving her neighbor's fence, Miss Daisy's car was totaled. Her insurance company reimbursed her in the amount of $24,500 ($25,000 less the $500 deductible). So, Miss Daisy had $18,500 ($24,500 minus the $1,000 purchase price and $5,000 in upgrades) of realized gain on the involuntary conversion of the property.
Miss Daisy spent the entire $24,500 of insurance proceeds on a replacement car and thereby qualified for a deferral of tax on all her gain. Her basis in the replacement car is $6,000, the cost of her new car reduced by the amount of her unrecognized gain ($24,500-$18,500=$6,000).
If she spent less than the full amount of insurance proceeds she received, say $20,000, she would recognize as taxable gain the amount not reinvested in the replacement vehicle, in this case $4,500. Her basis in the new car would still be $6,000. If she reinvested less than $6,000 in her replacement vehicle, she would recognize a taxable gain of $18,500, and her basis in the new car would be equal to the purchase price.
When Is Loss Deductible?
Casualty losses must generally be deducted in the tax year in which the loss event occurred. However, if you suffered a loss in a presidentially declared federal disaster area, you may deduct your loss in the preceding year.
To do this, you must file an amended tax return for the preceding year, and figure the loss and the change in taxes exactly as if the loss actually occurred in that preceding year.
If you did not itemize your deductions in that preceding year, you can go back and add any other itemized deductions (such as mortgage interest, taxes, charitable contributions etc.) that you would have been able to deduct in that year. You generally must make this choice by the due date (not including extensions) for the tax return of the year that the loss actually occurred.
If your losses were very large, and exceed your income for the year, you may have a net operating loss (NOL) for the year. You can use an NOL to lower your taxes for a previous year, allowing you to get a tax refund for the earlier year.
You don't have to be in business to claim an NOL due to a casualty or theft loss, but the rules for claiming NOLs are fairly complex, and we recommend that you consult your tax advisor for advice on the mechanics of amending your prior year's return to claim this deduction.
Calculating and Reporting the Casualty Deduction
You must complete Form 4684 for all casualty losses. However, the rules for determining the amount of deductible loss and where the loss is reported on your income tax return vary depending upon whether the loss is business property, investment property, or personal-use property.
Reporting Casualty Losses to Business or Income-Producing Property
For losses of trade or business property, or property used to produce rentals or royalties, once you've calculated the amount of your loss and subtracted the amount of your reimbursement, the remainder is your deductible loss (or gain).
For losses of income-producing property that is not described above (for example, investments such as stocks, bonds, gold, silver, and works of art), your casualty losses are added to your itemized miscellaneous deductions. All of these deductions are added together, two percent of your adjusted gross income is subtracted, and the remainder is your deductible amount.
If you had a loss to income-producing property, complete Section B of Form 4684, and transfer the loss to Schedule A as a miscellaneous itemized deduction. If you had a gain to income-producing property, or if you had a gain or loss to trade or business property or rental or royalty property, complete Section B of Form 4684 and then transfer the gain or loss to Form 4797, Sales of Business Property. Again, you can elect to postpone tax on the gains by purchasing replacement property and attaching a statement to that effect to your tax return, as described above.
Reporting Casualty Losses to Mixed-Use Property
If you suffered damage to your home, part of which you were using as a home office, or to your car, which you sometimes used for business, you have mixed-use property and your loss must be proportionately divided between the two types of usage. You will actually treat the event as if it were two separate losses. The $100 and 10 percent of AGI reduction applies only to the personal portion of the loss. Some special considerations apply in the case of home offices.
Reporting Casualty Losses to Personal-Use Property
For thefts or casualties of personal or family property, your deductible loss is much more strictly limited. Generally, after calculating the amount of your loss and subtracting any reimbursements, you must subtract $100 for each casualty, theft, or accident you suffered during the year, regardless of the number of items that were damaged or destroyed during the event.
If you have a loss to personal-use property, you must fill out Section A of Form 4684, Casualties and Thefts. Each item is reported in a separate column on this form (if a large number of items were lost or damaged, you can use reasonable categories such as "clothing," "jewelry," "furniture" etc.)
Separate copies of Form 4684 must be used if you suffered more than one casualty during the year; transfer the amounts from Line 12 of all the forms you used to Line 13 on one of the forms and use that as the "master" for the remainder of the questions. Ultimately, you will transfer the loss amount to Schedule A as an itemized casualty loss deduction.
Reporting casualty gains. If you have a taxable gain as a result of a casualty to personal-use property, use Section A of Form 4684, and transfer the gain amount to Schedule D, Capital Gains and Losses, on your individual income tax return (Form 1040). The gain will be treated as short-term or long-term, depending on whether you held the property for one year or less, or for more than one year.
If you elect to defer gain by purchasing qualified replacement property, you won't have to transfer the gain to Schedule D, but you must attach a statement to your tax return explaining the date and details of the casualty or theft, the amount of insurance, how you figured the gain, and that you are choosing to postpone gain by purchasing replacement property.
If you've already done the replacing, include information about the property, the postponed gain, the basis adjustment that reflects the postponed gain, and any remaining (unpostponed gain) you are reporting on Schedule D. If you make the replacement in a later year, attach a statement including this information about the replacement property to the tax return for that later year. If you expected to replace property but then didn't, or replaced at less than the full amount, you'll have to go back and amend your tax return for the year you claimed the loss.
Applying the $100 reduction and 10 percent reduction. If you are married filing jointly, a single $100 reduction applies for each event, but if you are filing separately, each spouse who claims a loss must subtract $100, for a total of $200 per event for jointly owned property. If only one spouse owned the property at issue and you are filing separately, that spouse is the only one who can claim a deduction, and he or she must apply the $100 reduction.
After the first $100 is subtracted, you're not in the clear yet: you must again reduce your deductible loss by a full 10 percent of your adjusted gross income as shown on Line 37 of your Form 1040. As a result, small personal casualty losses are unlikely to bring you any tax benefits.
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