This article is part 2 of a three-part series which discusses how to determine the amount of the loss for personal use and income producing property, amount deductible, and tax year for the deduction (part 1 can be found here). We will discuss gains, including deferring the gain for income producing property by purchasing replacement property-qualifying property, time period for replacement, realized and recognized gain, and basis of new property in the final installment.

Measuring the Casualty Loss

Non-income Producing Personal Use Property:

 

Whether the loss is total or partial, the loss is measured by the difference between the fair value before and after the casualty. If the assets are completely destroyed or stolen and not recovered, the value after the casualty will be zero. The total amount of all items destroyed or damaged in one event are reduced by any reimbursement and $100.

Example: A taxpayer was out of town from December 24, 2015 to January 10, 2016. When he got home, he found his house was broken into while he was gone and called the police. The police arrested the thief and determined the break-in occurred December 27. The following items were stolen: a diamond necklace worth $3,500, an iPad worth $800, and a TV worth $500. The insurance company paid $3,700 ($4,200 depreciated value, less a $500 deductible). The taxpayer’s $1,100 loss ($4,800 cost – $3,700) is reduced by $100 because the losses occurred in one event. The casualty loss deduction will be $1,100, less $100 and 10% AGI. It must be deducted in 2016, the year the loss was discovered.

Bank Deposit Losses

 

If a bank fails and is uninsured or the insurance does not full cover the losses of deposits, either a bad debt or casualty loss deduction may be claimed. A non-business bad debt is treated as a short-term capital loss. These losses may not be claimed by shareholders having more than a 1% ownership interest and officers or relatives of officers or shareholders.

If the deposits are an investment and none of the funds are insured, and you can reasonably estimate the amount, the uninsured loss, up to $20,000 ($10,000 for married separate, single, or head of household) is treated as a miscellaneous itemized deduction reduced by 2% of AGI (Schedule A, line 28). The dollar limits applies to total losses with any ONE financial institution regardless of how many accounts you have. If your loss exceeds $10,000 or $20,000, the excess may be claimed as a casualty loss reduced by $100 and 10% of AGI for total casualties.

If you treated the loss as a non-business bad debt deduction in a prior year you may file an amended return (Form 1040X within three years from the due date of the original return, including extensions) to treat it as a miscellaneous itemized deduction. A taxpayer is not likely to benefit from this because miscellaneous deductions are reduced by 2% of AGI and total itemized deductions are phased out when AGI exceeds certain amounts. But a non-business bad debt is treated as a short-term capital loss, which offsets capital gains and ordinary income up to $3,000. Any unused loss can be carried over to future years.

Reducing capital gains is very important because net investment income is subject to a 3.8% surtax for taxpayers with AGI of $200,000 ($250,000 for joint return).

Repairs as a measure of the loss

 

If the property is damaged but not completely destroyed, the cost of repairs can be used as a measure of the loss. But you cannot deduct the cost of repairs that restore the property to a better condition than it was before the casualty.

Example: Claire lost control of her 10-year-old SUV on an icy road and ran into a tree. It cost $25,000. At the time of the accident, the rear fender was rusted and had several holes in it. The repairs cost $9,500, including $1,500 to replace the rusted fender. Her collision insurance policy had a $500 deductible and insurance paid for the damages except the cost to replace the fender because of the rust damage. Her casualty loss is $8,000 (cost of repairs, excluding $1,500 for the fender). Her casualty loss deduction is $400 ($500 deductible, less $100 and 10% of AGI). She cannot include the cost of replacing the rusted fender because by replacing the rusted fender, the car is in better condition than it was before the casualty.

Theft

 

Theft (including embezzlement) losses are deductible in the year discovered, not the year of occurrence. Casualty losses are reduced by $100 per event, not for each item stolen. If you are a victim of a Ponzi scheme, the theft loss is first reported on Form 4684, part B as a casualty from investments, but is not subject to the $100 and 10% of AGI. Other type of theft losses include:

• Worthless securities due to purchases based on false and fraudulent representations (deductible in the year there is no prospect of a reasonable recovery).
• Kidnapping ransoms are allowable, but the expense of finding an abandoned person is not deductible.
• The IRS and the courts have disallowed casualty losses from confiscation of property, including bank deposits by foreign governments. But the loss may be claimed as a short-term capital loss.
• A taxpayer who was swindled out of $2 million by a friend because she gave her friend the money to buy stock in the friend’s bank. The IRS disallowed the loss claiming the taxpayer did not prove that fraud occurred; however, the district court overruled the IRS.

Business Assets

 

The amount of the loss depends on whether the asset was totally or partially destroyed. If the asset is totally destroyed, the loss is the adjusted basis of the asset. If it is partially destroyed, the loss is the difference between the fair value before and after the casualty or the cost of repairs. If the assets are completely destroyed or stolen and not recovered, the value after the casualty will be zero.

Business casualty losses are not reduced by $100 or 10% of AGI. The losses are first reported on Form 4684 and then transferred to Form 4797. If the asset was held one year or less it will be reported as an ordinary loss in part II. If it was held for more than one year, it is a Section 1231 loss reported in part 1.

If the loss occurs in a presidentially declared federal disaster area, you may deduct the loss either in the year the loss occurred or on the prior year return any time on or before the later of (1) the due date of the return, excluding extensions, for the year of the disaster, or (2) the due date of the prior year return, including any extension. If the prior year return has been filed, an amended return (Form 1040X for individuals or 1120 X for corporations) can be filed. An amended return must be filed.