Things happen. Tornadoes, fires, floods, accidents, and other unexpected events can change your life in the blink of an eye. The impact of these events on your personal and financial life can be devastating. You can lose property, financial records, and, in extreme cases, be forced to relocate to a new home. If your property is damaged or destroyed in a casualty event, such as a fire, storm, or flood, you hope your insurance will cover all or most of your loss. However, if your insurance falls short, you may receive some financial break by claiming a tax loss for the damage. This post provide information, guidance and easy tips on how deduct property losses and get financial breaks by claiming a tax loss for damage.
There is no dollar limit on how much you can deduct, but you must itemize deductions (in lieu of the standard deduction) to write off personal casualty losses. What’s your loss? The tax rules are cold and strict; your loss is limited to the decrease in the value of the property from the casualty or its adjusted basis (usually your cost), whichever amount is smaller. If property is damaged or destroyed, follow these rules of thumb:
- For property that had appreciated from the time you acquired it to just prior to the event, your loss is based on adjusted basis.
- For property that had declined in value from the time you acquired it to just prior to the event, your loss is based on fair market value.
Example: You bought a painting for $20,000 that is completely destroyed by a fire. Immediately before the fire, the painting’s value was $100,000. Your homeowner insurance policy does not cover this item and you do not have a separate policy to cover fine arts. Your tax loss is based on your adjusted basis of $20,000, which is less than the painting’s value of $100,000.
Your car is totaled in an accident and you don’t have collision coverage on it. You paid $20,000 for the car, and it was worth $8,000 before the accident and just $1,500 scrap value after the accident. Your tax loss is based on the decrease in the value, or $6,500 ($8,000 ? $1,500); this is less than the car’s adjusted basis of $20,000
Factors Reducing Your Deduction
Even if you have a loss, this doesn’t guarantee that it will be deductible. There are two tax law reductions of personal casualty losses:
- You must reduce each casualty loss by $100. This applies per casualty, not per item in the casualty event. If you have the misfortune to suffer two casualties in the same year, say a fire and a car accident, then you have two $100 subtractions.
- You must reduce your deductible loss by 10 percent of your adjusted gross income (AGI). This factor will substantially reduce your deduction and may prevent you from claiming any write-off.
Example: A hurricane damages your home and your uninsured losses, after reducing them by $100, are $7,600. If your adjusted gross income is $76,000 or more, you cannot take any casualty loss deduction. If your AGI is, say, $50,000, your deduction is limited to $2,600 ($7,600 ? $5,000).
Unfortunately, you can’t recover losses that are sentimental or of personal value. The family photo album that’s lost in a tornado won’t give you any tax break; it may have tremendous personal value but no value for tax purposes. Storing photos online is one way to protect these irreplaceable items from loss.
So what hat to do? Obtain an appraisal to determine the value of property before and after a casualty. Online resources for finding a qualified appraiser:
- American Society of Appraisers (www[dot]appraisers[dot]org)
- Foundation of Real Estate Appraisers (www[dot]frea[dot]org)
- International Society of Appraisers (www[dot]isa-appraisers[dot]org).
Use the cost of repairs as a measure of your loss. Restoration costs are viewed as the amount of your loss if you make only necessary repairs to bring the property back to its pre-casualty condition.
When to Deduct Property Loss?
Usually, you take the deduction in the year in which the casualty occurs. However, if the casualty is a disaster event, where your local area is designated by the U.S. president as qualifying for federal disaster relief, you can choose instead to deduct the loss in the prior year. This can create a tax refund for the prior year, giving you immediate cash to use for rebuilding.
Whether it’s a good idea to claim the disaster loss in the prior year depends on your personal tax situation. You’ll get the most tax mileage for the deduction in the year in which your adjusted gross income is lower (because of the 10- percent-of-AGI threshold explained earlier).
Disaster Relief Payments
If you are the victim of a disaster, you may receive assistance from the government or from nonprofit organizations. These payments to you are tax free, regardless of amount. Examples of tax-free disaster relief payments made because of a federally declared disaster:
- Personal, family, living, or funeral expenses.
- Expenses for the repair or rehabilitation of a personal residence, whether you own or rent the home.
- Expenses for the repair or replacement of the contents of a home.
How If You Gain on Your Casualty Loss?
Having property damage because of a casualty event doesn’t mean you have a tax loss. You may even have a tax gain. This results when the insurance proceeds and other recoveries you receive are greater than the adjusted basis of the property. For instance, in the example discussed previously, if you had insured the painting for $100,000, its value, you’d have an $80,000 gain as a result of the fire ($100,000 less $20,000 adjusted basis). The tax law calls this an involuntary conversion.
Fortunately, if you have an involuntary conversion that gives you a tax gain, you don’t necessarily have to pay tax on this gain now. You can postpone the tax by reinvesting the proceeds into replacement property within set time limits:
- Two years for losses to personal property (other than a home’s contents). The two-year period starts on the date of the damage or destruction and ends two years after the end of the first year in which any part of your gain is realized.
- Three years for business or investment real estate (not including inventory).
- Four years in the case of casualty to your home and its contents.
- Five years in special circumstances. For instance, the government extended the replacement period for victims of 9/11, Hurricane Katrina, Greensburg, Kansas tornado, 2008 Midwest floods, and Hurricane Ike.
The replacement property doesn’t have to be an exact match to what was destroyed. However, it must be similar or related in service or use. One residence must be replaced by another, although one could be a single-family home and the other a condominium. Replacing a residence with vacant land won’t qualify for postponing tax on gain.
Involuntary Conversion of a Principal Residence
Instead of postponing gain by buying a replacement home, you can exclude gain under the home sale exclusion rules. Assuming you owned and used the home as your principal residence for at least two years prior to the casualty event and the home is considered destroyed, then gain can be excluded up to $250,000 ($500,000 on a joint return).
Destruction need not be total, but it must be so substantial that it is viewed as a full destruction. The IRS says that only a full destruction (not a partial one) qualifies for the home sale exclusion. A “full destruction” means that the home is damaged to such an extent that the remaining structure can’t be used to advantage in restoring the home to its pre-casualty condition. Another measure of full destruction is having the cost of repairs substantially exceed the fair market value of the home prior to the casualty.
If the gain from the involuntary conversion exceeds the home sale exclusion, you can postpone tax on the excess gain by obtaining a replacement home within the four-year time limit explained earlier.
So what to do? If you are the victim of a disaster, check with FEMA (www[dot]fema[dot]gov) and local agencies to see whether you are entitled to any grants, relief payments, or other benefits.
In addition to having a choice of when to deduct your loss, other federal tax breaks may be yours: extended due dates for filing returns and making IRA contributions, abatement of interest and penalties on underpayment of income tax for the length of any postponement of tax deadlines. If there are any special tax breaks for your casualty event, the IRS will publicize them as news items on its web site (www[dot]irs[dot]gov).