Casualty Under The Internal Revenue Code—Part 1

Harold Goedde

This article is part 1 of a three-part series which will discuss the meaning of a casualty under the IRC. Over the next two installments, we will discuss how to determine the amount of the loss for personal use and income producing property, amount deductible, and tax year for the deduction. Also we will look at 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.

Definition of a Casualty

 

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, 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 lost items, rust, erosion, drought, water damage from leaking windows or gutters, and termite damage [Kiplinger’s Your Income Tax, 2016].

Examples of questionable events where the loss was allowed or disallowed [Kiplinger’s Your Income Tax, 2016]:

  • 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.
  • The Tax Court overruled the IRS 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.
  • A taxpayer’s house was near O.J. Simpson’s, where he killed Nicole Brown 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.
  • 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 there 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.
  • 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.
  • 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.
  • 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 foresee-ability 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 future cases.
  • 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.
  • 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.
  • Taxpayers built two homes but did not obtain the necessary building permits because they wanted to live without government interference. Several years later, the homes were destroyed by a fire and the taxpayers claimed a casualty loss in the year of destruction. The IRS disallowed the loss on the grounds that the taxpayers did not comply with state and county laws. The IRS said if the deduction were allowed, this would “severely and completely frustrate the State policy of obtaining permits before building a home.” The IRS further said: “it would make the federal government the insurer of the last resort for unpermitted, illegal homes.”

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

Occasionally, in prior years, the courts have disallowed deductions where the taxpayers’ actions would “severely and immediately frustrate national or state policy.” One court disallowed a theft loss deduction for money stolen from a taxpayer who participated in a counterfeiting scheme. Whether a court allows deductions for these kind of casualties depends on the facts of each case, such as whether the taxpayers actions directly the loss-e.g., arson. The taxpayers appealed the IRS disallowance to the Tax Court. The Court held there was no direct link between the taxpayers’ failure to obtain a building permit and the fire loss. Failure to obtain required building permits was not a sufficient reason for the IRS to deny their casualty loss deduction.

The loss was denied because the taxpayers failed to provide sufficient evidence of the loss and the amount claimed [Chief Counsel Memorandum ILM, 201346009].

Who may deduct a loss [Kiplinger’s Your Income Tax, 2016]?
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 owned. If she itemizes her deductions, the loss must 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 can’t deduct it.

(3) Leased property:

  • 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.
  • 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.
  • 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, 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 not deduct a loss until the year in which the insurance proceeds are received.

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 place 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 (for example, 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. 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

Dr. Goedde is a former college professor who taught income tax, auditing, personal finance, and financial accounting and has 25 years of experience preparing income tax returns and consulting. He published many accounting and tax articles in professional journals. He is presently retired and does tax return preparation and consulting. He also writes articles on various aspects of taxation. During tax season he works as a volunteer income tax return preparer for seniors and low income persons in the IRS’s VITA program.

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