The complexities of the section 165(i) (1) disaster loss election.

• Author: Crawford, Dean
• Position: Internal Revenue Code section 165(i - 1

The treatment of disaster losses is becoming an increasingly important issue in tax practice. Insurance industry experts have projected that a $50 billion disaster in the U.S. is a very real possibility in the near future.(1) Insurance companies are responding to the growing number of losses by increasing rates to prohibitively high levels. In high-risk areas (e.g., coastal Florida), some insurers have declined to renew existing policies or accept new business.

If the magnitude of disaster losses in the U.S. continues to increase,(2) more and more tax practitioners will be called on to aid clients in maximizing the tax benefits of a disaster loss deduction (DLD). Sec. 165(i)(1) defines a disaster loss as ". . . any loss attributable to a disaster occurring in an area subsequently determined by the President of the United States to warrant assistance by the Federal Government under the Disaster Relief and Emergency Assistance Act...." The tax treatment of disaster losses differs from the treatment of other casualty losses. While casualty losses are deductible in the year of occurrence, disaster losses can be deducted (at the taxpayer's election) in either the year of occurrence or the previous tax year. This choice gives taxpayers the opportunity to obtain tax refunds more quickly; the rapid infusion of cash into a damaged community helps it to begin the rebuilding process.

The possibility of a quick tax refund is attractive for taxpayers suffering the cash demands stemming from a disaster. However, the Sec. 165(i)(1) election to deduct a disaster loss in the year preceding the loss year may result in a greater total tax than if the election had not been made. Often, the appropriate year to claim a disaster loss is not obvious; it can be affected by (among other things) the difference in tax rates between long-term capital gain and ordinary income, the treatment of net operating losses (NOLs), and, for individuals, the various adjusted gross income (AGI) limits and thresholds. This article illustrates the complexity inherent in deciding the proper year to claim a DLD, highlights some of the tax issues that complicate the choice and explains how to ensure the maximum tax benefit.

Computing the DLD

Generally, the magnitude of the DLD depends on the decline in the asset's fair market value (FMV) resulting from the disaster. A qualified appraiser can estimate a property's FMV after the disaster.(3) However, the asset's FMV immediately before the disaster may be difficult to determine, especially if the property was acquired many years before the loss year and there have been no comparable purchases or sales in the recent past. It may be advisable for taxpayers to obtain periodic appraisals (or make detailed video records) of significant assets.

The computation of the DLD hinges on whether (1) the taxpayer is a corporation or individual and (2) the affected property is business, investment or personal use property.

Trade/Business, Rental and Royalty Property

If the property is owned by a corporation or used by an individual in a trade or business including for the production of rents or royalties), the DLD equals the "property loss" less any amount recovered or recoverable (e.g., an insurance reimbursement). If the asset is completely destroyed, the property loss is the asset's adjusted basis; if the asset is merely damaged, the property loss is the lesser of (1) the decrease in the asset's FMV attributable to the disaster or (2) the asset's adjusted basis. The DLD is reported on Form 4684, Casualties and Thefts, Section B, and, for individuals, carried to Form 1040, Line 14, as an "above the line" deduction. For C corporations, the DLD is carried to Form 4797, Sale of Business Property, if that form is otherwise being filed; if not, the DLD flows to Form 1120, Line 9, on which "From Form 4684" should be written.

Investment Property

Investment property is property that produces income (e.g., interest and dividends) or is held with the expectation it will appreciate in value. Investment property differs from business property in that the income generated does not require a high level of taxpayer participation. For this purpose, investment property excludes property that produces rents or royalties.

Generally, a disaster can affect only tangible investment property (e.g., a painting or stamp collection); intangible investment property (e.g., stocks or bonds) usually cannot be so damaged. A stock certificate may be destroyed, but the taxpayer's ownership of the shares of stock is not changed (an exception would be bearer securities).

A DLD on property held by an individual for investment purposes is calculated in the same manner as a DLD on business property, and is also reported on Form 4684, Section B. However, the deduction is a miscellaneous itemized deduction (Schedule A, Line 22), rather than above the line. A C corporation taxpayer takes an investment property loss in the same manner as a business property loss. If the investment property is a capital asset, the corporation can deduct the capital loss only to the extent of its capital gains.

Personal Use Property

If the affected asset is personal use property, the DLD is computed differently. First, regardless of whether the asset is destroyed or only damaged, the property loss is the lesser of (1) the decrease in the asset's FMV attributable to the disaster or (2) the asset's adjusted basis. Second, the potential DLD is reduced by (1) a $100 de minimis threshold that applies on a per-casualty basis (e.g., if five assets are damaged in a tornado, the $100 reduction applies once to the entire loss); and (2) a 10%-of-AGI threshold that applies to the total net property loss for the year.

Example 1: In 1997, X suffered a flood in April, a tornado in June and a hurricane in September, causing disaster losses of $5,100, $7,600 and $10,100), respectively. X's 1997 AGI is $100,000 and he received $2,000 in insurance proceeds from the disasters. X's DLD is $10,500 (the $22,800 property loss ($5,100 + $7,600 + $10,100) -...