On September 30, 2010, the Internal Revenue Service (IRS) issued Rev. Proc. 2010-36 addressing casualty loss deductions under [section] 165(a) of the Internal Revenue Code (1) for taxpayers whose personal residences were found to contain defective Chinese drywall. Although useful to some taxpayers, for many the guidance is a narrowly drawn safe harbor procedure that may provide limited or no relief for the taxpayer who does not have the means to repair or remediate the property. Even worse, Rev. Proc. 2010-36 does not provide any safe harbor relief for the many taxpayers who purchased defective drywall homes as investment property and trade or business property during the building boom. Unfortunately, it appears that more than walls stink for Chinese drywall victims.
Since 2001--and more significantly in the construction boom from 2003 to 2007--property owners across the United States have been reporting the corrosion of copper wiring, failures of household appliances with copper components, and the presence of sulfur gas odors within their homes and buildings. Occupants of the structures reported suffering from nausea, eye irritation, and respiratory problems. (2) Florida and Louisiana, states with the largest glut of new housing construction from real estate booms and a series of devastating hurricanes in the mid 2000s, sourced the majority of these reports. (3) The Florida Department of Housing (DOH) received its first report in June 2008, and after further complaints from homeowners and inquiries made by the Environmental Protection Agency, the DOH launched an investigation in conjunction with the Consumer Safety Product Commission (CSPC) to determine the cause of the problems and assess any possible health risks. (4)
Several South Florida builders knew the source of the problem as early as July 2006. The odors and corrosion were the result of a high sulfide gypsum and oil shale mix of drywall imported from China between 2001 and 2008.5 As some homeowners were quietly moved by builders to begin remediation in late 2008, news of the epidemic known as "Chinese drywall," "defective drywall," "corrosive drywall," and "problem drywall" became widespread in January and February 2009 as it hit local and national media.
Although the presence of Chinese drywall was unmistakable for the many homeowners suffering from the rotten egg odor the drywall had been emitting for years, it was not until January 2010 that the CSPC released guidelines to officially identify the presence of the corrosive drywall. (6) Since the announcement of these guidelines, over 3,805 reports of problem drywall in 43 states, the District of Columbia, Puerto Rico, and American Samoa have been logged with the CSPC. (7) Unfortunately, there are a significant number of unreported cases as a result of speculators who defaulted on mortgages and walked away from homes they never lived in or even saw, leaving the banks to "clean up" the mess. While some homes need only a few boards removed, the majority of homes must be completely gutted of all drywall, corroded copper, and electrical wiring at a cost typically in the hundreds of thousands of dollars. Acknowledging the gravity of the situation, the state of Florida mandated the removal of all corrosive drywall homes from county tax rolls in 2010 and requested assistance from the Federal Emergency Management Agency (FEMA).
The Government's Response
FEMA rejected Florida's request for damage assessment and financial assistance for homeowners by stating that it did not meet federal emergency or disaster guidelines. (8) This insult was met with further injury months later when the IRS issued
Rev. Proc. 2010-36 to provide "help" for defective drywall victims. (9) Under Rev. Proc. 2010-36, the IRS provides a safe harbor method for taxpayers whose personal residences were affected by the corrosive drywall. After properly identifying the presence of the corrosive drywall under the CSPC guidelines, the IRS mandates that a taxpayer must remediate the home and repair any such damage caused by the problem drywall to take a deduction under its safe harbor method. As with all personal casualty loss deductions under [section] 165(c)(3), [section] 165(h) limits the deduction to losses exceeding $100 and 10 percent of the taxpayer's adjusted gross income for the tax year. (10)
Nowhere within [section] 165 is there a requirement that a taxpayer actually pay for the repair or replacement of an asset that has been damaged, destroyed, or stolen. The underlying policy reason for this is simple: The losses or damages may be so great that taxpayers cannot afford to make themselves whole again. The IRS recognized this concept when it promulgated Rev. Proc. 2006-32 to deal with taxpayers whose personal use real property was destroyed or damaged as a result of Hurricanes Katrina, Rita, and Wilma. (11) The IRS allowed homeowners to take a deduction for the damage done to their home as assessed by insurance agencies, contractors, or cost indexes. (12) None of these three safe harbor valuation methods provided under Rev. Proc. 2006-32 required the taxpayer to reach into his or her pocket to remediate the home to take advantage of the deduction. Additionally, under Rev. Proc 2006-32, the IRS waived the $100 and 10 percent of adjusted gross income loss limitations under [section] 165(h).
The stark contrast between the relief granted to the 2004 and 2005 hurricane victims under Rev. Proc 2006-32 and the drywall victims under Rev. Proc. 2010-36 in what has been called the "silent hurricane" becomes even more apparent when a taxpayer elects to take a deduction outside of the safe harbor method. Under Rev. Proc. 2010-36, taxpayers with Chinese drywall electing not to follow the safe harbor procedure must prove every element of a [section] 165 casualty loss, including whether defective drywall qualifies for a loss deduction under [section] 165, including the measure of the loss, which can often be a complicated and confusing task in a defective drywall case.
The Basics of [section] 165 Casualty Losses for Personal Property
Under [section] 165(a), taxpayers may deduct losses not compensated...