From Thomson-Reuters —
If you are unlucky enough to suffer a disaster-related casualty loss, some of the costs can be mitigated through tax relief. This article explains the federal income tax implications.
Limited deductions for personal casualty losses
In theory, our federal income tax rules allow you to claim an itemized deduction for personal casualty losses that are not covered by insurance. A casualty loss occurs when the fair market value of an asset is reduced or wiped out by hurricane, wind, flood, fire, earthquake, volcanic eruption, sonic boom, and the like, or by theft or vandalism.
Unfortunately, many disaster victims won’t qualify for personal casualty loss write-offs because of the following two rules.
- You can only deduct personal casualty losses that are due to a federally declared disaster. So, if your basement floods because you accidently left the upstairs bathtub water running for two days, you get no tax deduction because the damage is not due to a federally declared disaster (that is, any disaster later determined by the President to warrant assistance by the federal government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act). You can find lists of federally declared disaster areas on the IRS website at gov/newsroom/tax-relief-in-disaster situations.
- Assuming your personal casualty loss is due to a federally declared disaster, you must first reduce it by $100. Then you must further reduce it by an amount equal to 10% of your adjusted gross income (AGI). AGI is the number at the bottom of page 1 of your Form 1040; it includes all taxable income items and selected deductions such as the ones for IRA contributions, self-employed retirement plan contributions, HSA contributions, and student loan
Example 1: You incur a $50,000 personal casualty loss from one of this year’s federally declared disasters. You have AGI of $150,000 for the year. Your federal income tax write-off will be only $34,900 ($50,000 – $100 – $15,000). You get no tax break if your loss before the two required subtractions is $15,100 or less, and you have no chance for a deduction unless you itemize. Finally, if your personal casualty loss is not from a federally declared disaster, you get no deduction.
Special deduction timing rule
Assume you have a net personal casualty loss from a 2022 federally declared disaster. What next? Since the loss was caused by a disaster in a federally declared disaster area, a special rule allows you to claim your federal income tax deduction on either (1) your 2022 Form 1040 (the year the casualty event occurred) or (2) an original or amended return for 2021 (the year before the casualty event occurred).
In effect, this beneficial rule allows you to claim the deduction in the year when it does you the most tax-saving good. For example, if your AGI was much lower in 2021 than this year, claiming a 2022 loss in 2021 could result in a much bigger deduction. Plus, if you claim the deduction in 2021, you don’t have to wait until after you’ve filed your 2022 return sometime next year to collect your tax savings.
Deductions for business casualty losses
If business assets are affected by a casualty loss, you don’t have to worry about the $100 subtraction rule or the 10%-of-AGI subtraction rule. And there’s no federally declared disaster requirement. You can deduct the full amount of your uninsured loss as a business expense.
As with personal casualty losses, you have the option of claiming deductions for business casualty losses that occur in a federally declared disaster area on either your return for the year the disaster occurs or on an original or amended return for the year before.
Beware of involuntary conversion gains
When you have insurance coverage for disaster-related property damage-under a homeowners, renters, or business policy you might actually have a taxable involuntary conversion gain instead of a deductible casualty loss. That’s because when insurance proceeds exceed the tax basis of the damaged or destroyed property, you have a taxable profit as far as the IRS is concerned. Your tax basis in an asset usually equals original cost plus the cost of improvements minus any depreciation deductions claimed for the property.
Involuntary conversion gains are given that name because the casualty event causes your property or asset to suddenly be converted into cash from the insurance proceeds.
For example, you could have a big involuntary conversion gain if your appreciated vacation home was heavily damaged or destroyed and your insurance coverage greatly exceeded what you paid for the property when you bought it years ago.
If you have an involuntary conversion gain, it generally must be reported as income on your Form 1040 unless you (1) make a gain deferral election and (2) make sufficient expenditures to replace the property with similar property by the applicable deadline. If you make the election (and you generally should when it is available), you’ll have a taxable gain only to the extent the insurance proceeds exceed what you spend to repair or replace the damaged or destroyed property.
The expenditures for repair or replacement generally must occur within the period beginning on the date the property was damaged or destroyed and ending two years after the close of the tax year in which you have the involuntary conversion gain.
Taxpayer-friendly rules for principal residence involuntary conversion gains
For federal income tax purposes, special beneficial rules apply to principal residence involuntary conversion gains. Specifically, you can make otherwise taxable gains go away under liberalized rules.
- First, you can use the principal residence gain exclusion to reduce or eliminate an involuntary conversion gain. The maximum gain exclusion is $250,000 for unmarried homeowners and $500,000 for married couples filing a joint To qualify for the maximum exclusion, you must have owned and used the property as your main home for at least two out of the last five years.
- If your principal residence was damaged or destroyed by an event in a federally declared disaster area, and you still have an involuntary conversion gain after taking advantage of the principal residence gain exclusion, you have four years (instead of the normal two years) to make expenditures to repair or replace the property and thereby avoid a taxable gain.
- If contents in your principal residence are damaged or destroyed by an event in a federally declared disaster area, there’s no taxable gain from insurance proceeds that cover losses to unscheduled personal property (so-called contents coverage). In other words, you need not replace the contents to avoid a taxable You can do whatever you want with that part of the insurance money with no federal income tax consequences.
- If you have insurance coverage for scheduled personal property contents (such as jewelry, antiques, artwork, coin and stamp collections, and so forth), you can treat the combined insurance proceeds for the residence and the scheduled personal property as a common (combined) pool of funds. As long as you spend all of the common pool of funds to repair or replace your residence and/or to repair or replace contents (whether scheduled or unscheduled) by the applicable deadline, you’ll have no taxable gain.
Example 2: In 2022, your main home and its contents are completely destroyed by a wildfire in a federally declared disaster area. Later in 2022, you receive insurance proceeds of $700,000 for the home, $150,000 for unscheduled personal property contents, and $30,000 for scheduled personal property contents (jewelry, artwork, and a coin collection). To keep this example simple, assume that you don’t qualify for any principal residence gain exclusion.
You cannot have any taxable gain on the $150,000 received for unscheduled personal property contents. You can do whatever you want with that money with no federal income tax consequences.
If you elect to postpone any taxable gain and then, before the deadline, you reinvest the remaining $730,000 of insurance proceeds in a replacement home and any type of replacement contents (whether scheduled or unscheduled, or both), you will have no taxable gain to report on your Form 1040. If you reinvest less than $730,000, you’ll have a taxable gain to the extent the $730,000 exceeds the amount you reinvest by the deadline. To avoid or minimize a taxable gain, you must reinvest in replacement property before 2027 (four years after the end of the tax year in which you would have otherwise had a taxable involuntary conversion gain).
Your tax basis in the replacement property equals its cost reduced by the amount of any gain that’s reduced or eliminated under the rules explained in this example. In effect, the reduced or eliminated gain is postponed until you sell the replacement property.
However, basis is not reduced by an involuntary gain on your residence that’s avoided by virtue of the principal residence gain exclusion break. That’s a permanent tax-saving benefit.
Also, to the extent you spend money to replace unscheduled personal property contents, the basis of the replacement personal property is not reduced by any gain that’s avoided under these rules.
For further reading on this topic, check out the IRS publication Disaster Assistance and Emergency Relief for Individuals and Businesses.
Contact KM&M CPAs for help
Contact the tax experts at KM&M CPAs if you have questions or want more information about the somewhat tricky federal income tax rules for casualty losses. We can be of help with any individual or business accounting or tax issue. To set up an appointment, call us at 419-756-3211, send an email to [email protected], or just fill out our website contact form at this link.