Casualty losses and expenditures under Sec. 162 or 165.

• Author: Skarbnik, John H.

Two Code provisions, Sec. 162 and Sec. 165, offer a potential deduction for a taxpayer who has property that has been damaged by a casualty. A taxpayer who uses property in a trade or business may be able to deduct expenses of repairing or restoring property damaged by a casualty under Sec. 162(a), which provides, "There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business."

Sec. 165 provides a deduction for casualty losses that are incurred (1) in a trade or business; (2) in a transaction entered into for profit, though not connected with a trade or business; and (3) except as limited, not connected with a trade or business or a transaction entered into for profit, if such loss arises from fire, storm, shipwreck, or other casualty, or from theft. (1) However, as discussed below, for tax years 2018 to 2025, deductions for personal casualty losses are generally limited to losses of property within certain federally declared disaster areas.

Whether a deduction is taken under Sec. 162 or Sec. 165 is important because a business expense is deductible when paid or incurred, while a casualty loss is deductible only when sustained and if not compensated for by insurance or otherwise. Also, a loss generally is measured by the difference between the value of the property before and after the casualty, limited to adjusted basis, and reduced by any insurance recovery, rather than the cost of repairs or replacements.

Casualty loss rules

The Internal Revenue Code allows all taxpayers to deduct losses arising from fire, storm, shipwreck, or other casualty for property used in a trade or business or a transaction entered into for profit. (2) Until 2018, an individual could claim a personal casualty loss for property not used in a trade or business or a transaction entered into for a profit (personal-use property) if the loss arose from fire, storm, shipwreck, or other casualty. (3) However, the deduction for personal casualty losses was greatly limited by the passage of P.L. 115-97, known as the Tax Cuts and Jobs Act of 2017. Under the act, no deduction is allowed for a personal casualty loss arising after Dec. 31, 2017, and before Jan. 1, 2026, with several exceptions. Between 2018 and 2025, a personal casualty loss may only be deducted (1) to the extent of personal casualty gains, or (2) where the property loss was attributable to a "qualified disaster loss," i.e., one attributable to a "federally declared disaster" determined by the U.S. president to warrant assistance under Section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act. (4)

The amount of the casualty loss is determined in the same manner whether the property is used by the taxpayer in a trade or business or a transaction entered into for profit or is personal-use property, such as a taxpayer's car or home. (5) However, a taxpayer's casualty losses from personal-use property are reduced by $100 per casualty and 10% of the taxpayer's adjusted gross income (AGI). (6)

For all three categories of casualty loss, a taxpayer must establish the amount of the loss by obtaining an appraisal that measures the difference between the fair market value (FMV) of the damaged property immediately before and immediately after the occurrence of the casualty. The appraisal must take into account the effects of any simultaneous general market decline affecting the property's value. (7)

In lieu of establishing the loss by appraisal of the FMV immediately before and immediately after the casualty, the regulations permit the taxpayer to establish the amount of the loss by the cost of the repairs, if the taxpayer shows (1) the repairs are necessary to restore the property to its condition immediately before the casualty; (2) the amount spent for the repairs is not excessive; (3) the repairs do not repair more than the damage suffered; and (4) the repairs do not increase the property's value to above its value immediately before the casualty. (8)

The total amount of a claimed casualty loss cannot exceed a taxpayer's adjusted tax basis in the property damaged. (9) The regulations provide that a taxpayer's casualty loss is the lesser of (1) the decrease in the value of the property, measured by the difference between the FMV of the property immediately before and immediately after the casualty, and (2) the taxpayer's adjusted basis in the property damaged. (10)

In addition, a casualty loss deduction under Sec. 165 may be claimed only to the extent that there is no prospect that the loss or a portion of the loss will be compensated for by insurance or other reimbursement. The regulations (11) provide:

If a casualty or other event occurs which may result in a loss and, in the year of such casualty or event, there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained, for purposes of section 165, until it can be ascertained with reasonable certainty whether or not such reimbursement will be received. Whether a reasonable prospect of recovery exists with respect to a claim for reimbursement of a loss is a question of fact to be determined upon an examination of all facts and circumstances. This limitation applies only to losses sustained under Sec. 165. As such, this limitation does not apply to casualty losses of property used in a trade or business or transactions entered into for profit by the taxpayer, though not connected with a trade or business, that are deductible under Sec. 162(a).

Example l: (12) A taxpayer's residence, which has a basis of $200,000, is severely damaged by a fire in 2017. The taxpayer spends $100,000 in 2017 repairing the damage to his home. The money spent by the taxpayer is not considered a betterment to the unit of property. (13) The insurance company and the taxpayer in November 2017 enter into a settlement agreement by which the insurance company agrees to pay $80,000 in full payment for the damage suffered by the taxpayer from the fire. The $80,000 insurance payment is made on March 15, 2018. In 2017, the taxpayer may claim a $20,000 loss ($100,000 repair cost minus $80,000 insurance settlement), since the taxpayer does not have any other claims for reimbursement. Since this loss is considered a personal casualty, it will be decreased by 10% of the taxpayer's AGI and $100. Also, note that if the fire had occurred after Dec. 31, 2017, under the change made by P.L. 115-97, the loss (to the extent greater than any casualty gains) would not be deductible at all, pursuant to new Sec. 165(h)(5), unless it was attributable to a federally declared disaster.

Example 2: Assume the same facts in Example 1, except the taxpayer also files a lawsuit in 2017 against a neighbor who negligently started the fire. There is a reasonable prospect that the taxpayer will be able to recover the remaining $20,000 in damages from the neighbor. Since the taxpayer has an outstanding claim at the close of 2017, he has a reasonable prospect of recovering the remaining amount of the loss. Therefore, no deduction is allowed for this portion of the loss in 2017 since the taxpayer may receive compensation for the damage to the residence. If the taxpayer's suit against the neighbor is dismissed in 2019, the taxpayer may claim the casualty loss of $20,000 in the 2019 tax year (decreased by 10% of the taxpayer's AGI and $100).

A taxpayer who claims a casualty loss deduction under Sec. 165 must capitalize the expenditures made to restore the property, to the extent the casualty loss results in a basis adjustment to the damaged property. (14)

If a taxpayer claimed a loss in accordance with the rules set forth in the regulations and in a subsequent year receives...