A casualty is a sudden unusual and unexpected event that damages or destroys your property. A sudden event is one that is swift. Unexpected is an event that is not anticipated and is unintended. An unusual event is one that is not-day-to day and is not typical of the activity for which the asset is normally used. To have a casualty, chance or a natural phenomenon must be present. Examples include fires, windstorms, tornadoes, hurricanes, floods, sudden landslides, vehicle accidents, theft, broken water pipes, and vandalism. Loses that are progressive and occur gradually over a period of time are not qualifying casualty losses. Examples are rust, erosion, drought, water damage from leaking windows or gutters, and termite damage. Lost items are also not casualties.

Examples of Questionable Events

[Kiplinger’s Your Income Tax, 2014]

1. The Tax Court overruled the IRS and allowed a loss where a ladies diamond was loosened and came out of the setting and never found when the car door slammed on her hand and she vigorously shook her hand to relieve the pain. The lady was powerless to prevent the loss due to the sudden impact of the door slamming on her hand.

2. Loses that are progressive and occur gradually over a period of time are not qualifying casualty losses and allowed a loss where a boat in poor state of repair was equipped with a pump that automatically operated when water in the hull rose above a certain level. One day the dockside power source failed and the pump did not work and the boat sunk in four hours. The IRS contended the leakage was a chronic problem and disallowed the loss. The Tax Court ruled the sinking was not a direct result of the boat leaking but was caused by the sudden failure of the boat water pump.

3. A taxpayer’s house was near O.J. Simpson’s where he killed Nicolle Simpson and Ron Goldman. The taxpayer claimed a $400,000 casualty loss due to the decline in value caused by permanent buyer resistance due to the adverse trial publicity and media frenzy. The IRS and the Federal District Court disallowed the loss. The Ninth Circuit Court of Appeals upheld the IRS stating that the loss was not due to physical damage or other sudden event. In a separate case, a decline in value of a house owned by O.J.’s neighbor was also disallowed by the Tax Court for the same reason.

4. In 2003, a taxpayer’s vacation home was damaged by an avalanche causing $9,000 of physical damage. The taxpayer claimed a $221,000 loss arguing that there was a permanent loss in value due to avalanche risk in the area. Local roads were blocked off during heavy snowfall and some residents decided not to rebuild destroyed homes. The IRS and the federal district court disallowed the $221,000 loss claimed. They said the loss could not exceed the actual physical damage and that their may have been a temporary buyer resistance but not a permanent change in the area. In its decision, the court cited a similar decision by the 11th Circuit Court of Appeals.

5. Many farmers have claimed losses for crops caused by drought. Generally, these losses are not allowed by the IRS based on the fact that the loss resulted from progressive destruction. But the Tax Court has allowed these losses for severe drought if the damage occurred in the same year as the drought. In cases where the loss was observed in a subsequent year, the courts have disallowed them because the losses were progressive.

6. The IRS allowed a loss to trees destroyed by southern pine beetles over a 5-10 year period. One court allowed the loss for similar damage occurring over a 30 day period. The court ruled the infestation damage occurred suddenly and could not be prevented.

7. A loss was disallowed by the IRS and the Tax Court for damaged property caused by a landslide. The taxpayer owned a hillside lot and had a home built on it. A soil test showed a high proportion of fine-grain unstable sandstone. The construction contract called for appropriate shoring up and support but due to the contractor’s negligence, a landslide occurred. The IRS disallowed the loss because the danger was known before the taxpayer undertook the project and the landslide was caused by contractor’s negligence. The Tax Court overruled the IRS stating that the contractor’s negligence was not a decisive factor in determining whether there was a casualty. The Court further said foreseeability is not a conclusive factor. The Court stated that automobile accidents caused by driver negligence is a casualty and that a weather report may warn people of a pending hurricane or tornado but losses caused by such storms are a legitimate casualty. The IRS agreed to abide by the Court’s decision in similar cases.

8. A plumber stepped on a pipe that was improperly installed causing underground flooding and $20,000 damage. The IRS disallowed the loss stating that it was caused by faulty construction. The Tax Court overruled the IRS stating the loss was caused by the plumber stepping on the pipe and improper construction was only an element in the causative chain.

9. Destruction of a lawn from careless use of weed killer was disallowed by the IRS. But the loss was allowed by the Tax Court because they said even though the taxpayer was negligent, the damage was caused by a sudden event.

A key element in casualties is that the loss is allowable despite taxpayer negligence.

Who May Deduct A Loss

[Kiplinger’s Your Income Tax, 2014]

Only the owner of the property can deduct a loss.

Examples:

(1) Spouses filing separate returns. The wife had an accident in a car she owns. If she itemizes her deductions, the loss must be deducted on her separate return. If the car is jointly owned, the loss is split and each spouse takes a deduction on their own return.

(2) Property owned by parents but the loss is caused by a dependent child. The parents can deduct the loss; however, if the child has reached majority age, the parents cannot deduct the loss.

(3) Leased property:

(a) If a lessor requires the lessee to make payments to compensate him for a casualty loss on the leased property, the lessee can deduct the payments as a casualty loss.

(b) The Tax Court does not allow a casualty loss deduction for damages to a rental car because the renter does not have any basis in the rental car.

(c) A taxpayer leased a lot to build a house on it and had the use of a nearby lake. A storm destroyed the lake causing the property to drop in value. The lessee can not deduct a casualty loss because he does not own the property. He only has the privilege of using the lake which is not an ownership right.

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’s was out of town from December 28, 2013 to January 8, 2014. 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 30. The following items were stolen: a diamond necklace worth $3.500, an I-pad worth $800 and a TV worth $500. The insurance paid for the value of the items stolen, less a $1,000 deductible. The taxpayers loss is reduced by $100 because the losses occurred in one event. The $900 ($1,000 deductible, less $100) net loss is then reduced by 10% of AGI and must be deducted in 2014, the year the loss was discovered.

Personal income producing assets

Losses from these assets are casualties and are reduced by $100 per event but are not reduced by 10% of AGI. They are reported as another miscellaneous itemized deduction (Schedule A, line 28), but are not reduced by 2% of AGI.

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 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 starting in 2013, 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

Joey lost control of his SUV on an icy road and ran into a tree. 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. Joey’s collision insurance policy had a $500 deductible. His insurance paid for the damages except the cost to replace the fender because the fender damage was not caused by the accident. Joey’s casualty loss deduction is $400 ($500 deductible, less $100). He cannot deduct 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 (1) worthless securities due to purchases based on false and fraudulent representations (deductible in the year there is no prospect of a reasonable recovery. (2) kidnapping ransom are allowable, but the expense of finding an abandoned person is not deductible. (3) 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. (4) 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 within three years from the due date, including extensions, of the original return.

Expected reimbursements for losses

If you are expecting a reimbursement in a later year, you cannot claim a loss until the year the reimbursement is received. But if you are not expecting a reimbursement and deduct the loss and then receive a reimbursement in a later year, you must report the reimbursement as other income in the year of reimbursement to the extent you took a casualty loss deduction in the prior year. If your property is covered by insurance, you must file a timely claim or the loss is not deductible to the extent of the insurance reimbursement you would have received had a claim been filed. If you are a cash basis taxpayer you can’t deduct embezzlement losses for funds not reported as income.

Gains

Gains from casualties occur if the reimbursement exceeds the adjusted basis of the property destroyed or decline in value or repairs if a partial loss. For individuals, the gain is a capital gain and reported on Schedule D. Gains from casualties of business property are reported on Form 4797. If the asset was held one year or less the gain will be reported as ordinary income in part II. If the asset was depreciable personal property, there will be depreciation recapture (ordinary income) under Section 1245, to the extent of the lesser of the gain or depreciation allowed or allowable. The depreciation recapture is reported on form 4797 in part II. If the asset was held more than one year, the balance of the gain, after depreciation recapture, is Section 1231 reported on Form 4797 in part 1. If the taxpayer is a corporation and the asset destroyed was a non-residential building depreciated using the straight line method, there is depreciation recapture under Section 291. Note: for an illustrations of the rules for depreciation recapture, see my article “Sales of Business Assets”.

Deferring the gain

A taxpayer may elect to defer the gain by reducing the cost of the replacement property by the lesser of the realized or recognized gain. The realized gain is the excess of the reimbursement over the adjusted basis of the asset if it is completely destroyed or the decline in value or cost of repairs if partially destroyed. The recognized gain is the difference between the replacement cost of the new property and the reimbursement for the loss of the destroyed property. Deprecation recapture applies to any recognized gain. To defer the gain, the replacement property must be “like-kind” and acquired within two or three years depending on what type of property was destroyed. If the property was a personal residence located in a presidentially declared disaster area, the replacement period is four years. The replacement period begins on the date of the loss and ends two, three, or four years after the end of the year in which the gain was realized. If a personal residence is destroyed and a gain is realized and the house is not replaced, all or part of the gain may be excluded under the sale of residence rules.

Substantiating (Proving) The Loss

A good way to document the casualty is taking a picture of the property destroyed. It is a good idea to take pictures of all your property and keep them in a safe or safe deposit box along with the purchase receipts. If the property was destroyed by a natural event (tornado, fire, flood) there may be a newspaper story and pictures. There may also be police and fire reports you can obtain. For repairs, obtain copies of the collision repair invoice, cancelled check or credit card receipt, and insurance check. Keep them, pictures and a description of the asset with your tax return to be able to substantiate the loss if the IRS audits your return. This information does not need to be sent with the tax return. A theft should be verified by a police report and witnesses who may have observed it (e.g., when your personal assets are stolen by a thief on the street or a neighbor observed a break-in). The newspaper may have published an article on the theft. A police report should always be made; otherwise, it may be inferred that you are uncertain the theft occurred and the loss may be disallowed. In one case, a theft of a diamond ring by a domestic employee was allowed by the IRS even though a police report was not made or an attempt to recover it because the owner feared the employee would charge her with false arrest [Kiplinger’s Your Income Tax, 2014].

The costs of documenting the loss (e.g., pictures and appraisals) are not part of the casualty loss. They are reported on Schedule A as a miscellaneous itemized deduction and reduced by 2% of AGI. Deductible casualty losses are not subject to the income based reduction of overall itemized deductions

In accordance with Circular 230 Disclosure