Personal casualty losses from natural disasters.

• Author: Godfrey, Howard

Many taxpayers have had reason in recent years to claim casualty losses caused by hurricanes, wildfires, and other natural disasters. Sixteen disasters each caused over $1 billion in damage in the United States in 2017. Hurricane Harvey damaged or destroyed over 200,000 homes and businesses. (1) Harvey also damaged or destroyed as many as 500,000 vehicles in Houston alone, and Hurricane Irma destroyed perhaps an equal number in all affected areas. (2) Many of these losses have been of property other than that used in a trade or business or for the production of income and thus potentially claimable as personal casualty losses.

This article explains the federal tax rules for calculating and reporting the deduction for losses of residential property and other nonbusiness property from natural disasters. Recent changes to the law and IRS guidance have made significant changes to these rules. These include, on the one hand, recent legislation and revenue procedures expanding or facilitating taxpayers' ability to claim personal casualty losses but also, on the other hand, the general limitation of the deduction of personal casualty losses to those resulting from federally declared disasters, under the tax reform law known as the Tax Cuts and Jobs Act (TCJA). (3)

Loss allowed under Sec. 165

Sec. 165(a) provides a deduction for a loss sustained by a taxpayer to the extent that the taxpayer does not receive insurance proceeds or other compensation for the loss. The basis used to compute the loss is the adjusted basis for determining loss on sale or other disposition of the property under Sec. 1011. (4)

Loss deductions for individuals

For an individual, a loss deduction is allowed under Sec. 165(c) only for:

* Losses incurred in a trade or business;

* Losses in a transaction entered into for profit but not connected with a trade or business; and

* Other losses (i.e., not incurred in a trade or business or in a transaction entered into for profit) that arise from fire, storm, shipwreck, other casualty, or theft.

This article refers to the first two types of losses described above as "business or investment" losses involving business or investment property. The third, other losses, are called "personal" casualty or theft losses. If personal casualty gains for the year exceed personal casualty losses, the gains are treated as capital gains and the losses are treated as capital losses, under Sec. 165(h)(2)(B).

Personal casualty loss limits for individuals

For an individual, Sec. 165(h)(1) provides that each personal casualty or theft loss is allowed only to the extent it exceeds $100. Thus, a personal casualty loss of $100 or less is disregarded. In addition, under Sec. 165(h)(2), when personal casualty losses exceed personal casualty gains for the year, the net total casualty losses are deductible only to the extent that they exceed 10% of the individual's adjusted gross income (AGI). Under Sec. 165(h)(5), added by the TCJA, a net personal casualty loss in calendar years 2018-2025 is deductible only to the extent it is attributable to a federally declared disaster. During this period, casualty losses that are not attributable to a federally declared disaster are deductible only to the extent of casualty gains.

Hurricanes Harvey, Irma, and Maria

Congress has provided special relief in the Disaster Tax Relief Act (5) for individuals with casualty losses from hurricanes Harvey, Irma, and Maria. There is a waiver of the requirement to reduce a personal net casualty loss deduction by 10% of AGI, but the $100 floor per casualty loss is increased to $500. A taxpayer's standard deduction is increased by the amount of a net disaster loss (a net casualty loss arising in the hurricane Harvey, Irma, or Maria disaster area). A taxpayer may realize more benefit by taking the standard deduction than by itemizing. IRS administrative safe harbors for computing the amount of casualty losses are described later in this article.

Amount of a casualty loss

Regs. Sec. 1.165-7(b) provides that the amount of a business or investment casualty loss, or a personal casualty loss, is the lesser of:

* The fair market value (FMV) of the property immediately before the casualty, minus the FMV immediately after the casualty; or

* The adjusted basis for determining the loss on the sale or disposition of that property.

However, if business or investment property was totally destroyed, and its FMV immediately before the casualty is less than its adjusted basis, the amount of the loss is equal to the property's adjusted basis (see the table "Casualty Loss for Auto" on p. 597).

Documenting the change in value

The FMV of property before and after a casualty event is generally determined from a competent appraisal. Under Regs. Sec. 1.165-7(a)(2)(i), a casualty loss deduction is limited to the decline in value of the property caused by the casualty. A flood or other casualty may cause potential buyers to anticipate possible future disasters, resulting in a general decline in property values in the area. Such a decline in value is not part of the casualty loss. In Bird, (6) the Tax Court accepted the amount paid for a residence less than a year before the casualty, plus the cost of improvements, as the pre-casualty value. In Woods, (7) the court accepted the selling price of a home sold soon after it was damaged by drought-related soil subsidence as a better measure of its value immediately after the casualty than an appraiser's opinion.

Repair cost as evidence of a decline in value

The cost of repairs to damaged property may be accepted as evidence of the decline in value under Regs. Sec. 1.165-7(a)(2)(ii) if:

* The repairs are necessary to restore the property to its pre-casualty condition;

* The amount spent for repairs is not excessive;

* The repairs are limited to the damage sustained in the casualty; and

* The repairs do not cause the value of the property to exceed its precasualty value.

Generally, the decrease in the value of the property may be determined using the cost-of-repairs method only if the taxpayer in fact repairs the property. In Lamphere, (8) the taxpayer was not allowed to use estimates of repairs that would be performed in the future or might not be performed at all. However, exceptions to this rule are provided in some safe harbors described later. The taxpayer may not include any repairs provided at no charge, such as those made by community volunteers, etc.

Definition of a casualty loss

The IRS and the courts have developed the overall concept that a casualty refers to an identifiable event of a sudden, unexpected, or unusual nature. For example, in Rev. Rul. 76-134, the IRS states that damage to buildings, docks, seawalls, etc. from winds and wave action during a storm may qualify as a casualty loss. However, progressive deterioration of property over time does not qualify as a casualty loss. Thus, damage to buildings, docks, and seawalls from gradual erosion does not qualify as a casualty loss under Sec. 165. The...