Analyzing the new personal casualty loss tax rules
Over the past decade, the United States has been plagued with myriad natural disasters. The National Oceanic and Atmospheric Administration reports that in 2017 alone, the country experienced 16 weather– and climate–related disasters costing more than $1 billion apiece and, in total, exceeding $306 billion, which far surpassed the previous record of $215 billion set in 2005. Many scientists are predicting more extreme weather–related events in the future.
Congress has responded to the most devastating of these natural disasters with tax relief for victims. Through the passage of the Disaster Tax Relief and Airport and Airway Extension Act of 2017, P.L. 115–63, and the Bipartisan Budget Act of 2018, P.L. 115–123, Congress eased the traditional personal casualty loss rules for the victims of hurricanes Harvey, Irma, and Maria, as well as those of the California wildfires. Additionally, with its issuance of Rev. Procs. 2018–8 and 2018–9, the Treasury Department introduced numerous safe–harbor methods that alleviate the nettlesome burden of determining personal casualty loss amounts.
Conversely, however, with the enactment of P.L. 115–97, known as the Tax Cuts and Jobs Act (TCJA), Congress charted a new course, essentially eliminating the personal casualty loss deduction for tax years 2018 through 2025, except for major disasters deemed to require federal assistance.
Before the TCJA imposed new limits, Sec. 165(c)(3) granted authority to individual taxpayers to deduct uncompensated personal casualty losses. Personal casualty losses are defined as those not incurred in a trade or business or in any transaction entered into for profit, and arising from “fire, storm, shipwreck, or other casualty, or from theft.” While neither the Code nor the Treasury regulations define a “casualty,” the IRS has interpreted it to be “an identifiable event of a sudden, unexpected, or unusual nature” (Rev. Rul. 79–174). No doubt, weather–related phenomena such as tornadoes, hurricanes, mudslides, and wildfires meet this definition; likewise, events such as car accidents, vandalism, and incidents of civil unrest would fall within its scope. Losses arising from progressive deterioration through a steadily operating cause, however, are not deemed to be casualties (e.g., termite damage or normal seasonal variations in levels of a body of water; see Rev. Ruls. 63–232 and 76–134).
Once a taxpayer ascertains the availability of a personal casualty loss, the next task is to determine the amount allowed. The Treasury regulations provide that personal casualty losses are equal to the lesser of (1) the adjusted basis for determining a loss on the sale of the damaged property, or (2) the decrease in the property’s fair market value (FMV) (Regs. Sec. 1.165–7(b)). A property’s FMV, both before and after the casualty, must be established by a “competent appraisal,” or its decrease can be evidenced by repair costs meeting the requirements of Regs. Sec. 1.165–7(a)(2)(ii). Once this determination is made, an adjustment must be made for “any salvage value and for any insurance or other compensation received” (Regs. Sec. 1.165–1(c)(4)).
There are three pivotal limitations to the allowance of personal casualty losses. First, the loss from each casualty is allowed only to the extent it exceeds $100 (Sec. 165(h)(1)). Second, aggregate losses for a tax year are allowed only to the extent they exceed the sum of (1) casualty gains and (2) 10% of the taxpayer’s adjusted gross income (AGI) (Sec. 165(h)(2)). Third, no deduction is permitted in a tax year for the loss, or any portion of it, when a claim for compensation is outstanding for which there is a “reasonable prospect” of recovery (Regs. Sec. 1.165–1(d)(2)).
Taxpayers report these net personal casualty losses as itemized deductions and can use them to offset ordinary income.
The Code generally requires a taxpayer to take a loss deduction in the year in which it is sustained. However, an election may be made to deduct losses incurred within a disaster area determined to warrant federal assistance and attributable to a federally declared disaster in the tax year immediately preceding the year in which the disaster occurred (Sec. 165(i)). The Treasury regulations state that an election made under Sec. 165(i) applies to all the losses suffered by the taxpayer as a result of the disaster to which the election pertains, and the disaster and its associated losses will be deemed to have occurred in the preceding tax year (Temp. Regs. Sec. 1.165–11T(c)). The president of the United States determines what constitutes a federally declared disaster and federally declared disaster area, based upon the need for aid under the Robert T. Stafford Disaster Relief and Emergency Assistance Act (Sec. 165(i)(5)).
It is worth noting that not all areas affected by a federally declared disaster are federally declared disaster areas. In the wake of Hurricane Harvey (a federally declared disaster), for example, only specifically enumerated parishes in Louisiana and counties in Texas were determined to be federally declared disaster areas, although numerous surrounding parishes and counties also suffered damage. Because those outlying parishes and counties were not designated as federally declared disaster areas, taxpayers who resided there could not elect to take their losses in 2016; instead, they were limited to claiming the deduction in 2017, when the losses were incurred.
In the wakes of hurricanes Harvey, Irma, and Maria, Congress speedily enacted legislation to help embattled storm victims. The IRS also provided relief with taxpayer–friendly administrative rulings.
The Disaster Tax Relief and Airport and Airway Extension Act
On Sept. 29, 2017, President Donald Trump signed the Disaster Tax Relief and Airport and Airway Extension Act of 2017 (Disaster Tax Relief Act). Among other relief, for damage resulting from hurricanes Harvey, Irma, and Maria, this legislation relaxed the traditional rules for deducting personal casualty losses. The key to securing tax relief was the presence of a “net disaster loss,” defined as qualified disaster–related personal casualty losses exceeding personal casualty gains.
Taxpayers who endured these hurricanes and suffered monetary damages as a result received welcome tax relief. While Congress implemented a $500 floor for claiming this tax relief, taxpayers could claim losses in excess of this threshold without regard to whether they exceeded 10% of the taxpayer’s AGI. Furthermore, all affected taxpayers were qualified to take this deduction, regardless of whether they itemized their deductions or claimed the standard deduction. Taxpayers who chose not to itemize their deductions could add these net disaster losses to their standard deduction. Finally, for the purpose of alternative minimum tax (AMT) computations, the net disaster loss portion of the revised standard deduction was not an AMT adjustment (unlike the standard deduction itself, which is normally an adjustment to the AMT base).
All or portions of several states, Puerto Rico, and the U.S. Virgin Islands were declared qualified disaster areas by reason of hurricane Harvey, Irma, or Maria.
On Feb. 9, 2018, in the Bipartisan Budget Act of 2018, Congress provided the same relief to victims of the wildfires that ravaged areas of California on Oct. 8 through Dec. 31, 2017.
As an additional form of relief, the IRS issued Rev. Procs. 2018–8 and 2018–9, in recognition of the fact that determining the amount of personal casualty losses under the regulations is not only difficult but can also be time–consuming and expensive. To alleviate this burden, these two revenue procedures introduce safe harbors that taxpayers may use to ascertain the decline in the FMV of their residences or personal belongings resulting from casualties.
Taxpayers are not required to use the new safe harbors but may instead continue to follow the measurement procedures outlined in the regulations. However, an attractive benefit for taxpayers opting to rely on these revenue procedures is that the IRS will not challenge taxpayers’ FMV determinations if the taxpayers qualify for and use one of the specified safe–harbor methods.
Rev. Proc. 2018-8
This revenue procedure details five safe harbors for measuring a decline in the FMV of “personal–use residential real property” that incurs a casualty. Personal–use residential real property is real property (with improvements) that contains at least one personal residence, such as a single–family home, owned by an individual taxpayer. A property is not considered a personal–use residence, however, if any part of it contains a home office used in a trade or business or transaction entered into for profit or is rented; the definition also excludes mobile homes and trailers and single building units of which the owner does not own the structural components (e.g., roof, foundation, and walls) or owns only a fractional interest in all the structural components.
While taxpayers may use any of the five safe harbors listed below to compute casualty damage amounts to personal–use residences resulting from federally declared disasters, only the first three safe harbors may be used by taxpayers who suffer casualties from other than federally declared disasters.
When applying any of the above methods, taxpayers may consider only costs to return a property to its original condition immediately before a casualty; costs of meeting newer construction codes and requiremements must be excluded.
Rev. Proc. 2018–8 also provides two safe–harbor methods, listed below, for measuring a decrease in the FMV of personal belongings resulting from a casualty. While either safe harbor may be used for federally declared disasters, only the first safe harbor may be used in the case of casualties from other than federally declared disasters.
Rev. Proc. 2018-9
Rev. Proc. 2018–9 also presents a safe harbor for measuring a decrease in the FMV of personal–use residential real property as the result of casualties. Unlike Rev. Proc. 2018–8, however, the relief it offers is available only to residents located in the “2017 Disaster Area” for damage resulting from one of the three 2017 hurricanes. The 2017 Disaster Area includes all of Florida, Georgia, Louisiana, Puerto Rico, South Carolina, Texas, and the U.S. Virgin Islands, without regard to a federal disaster declaration.
The virtue of Rev. Proc. 2018–9 is that it offers a cost index safe harbor. More specifically, it contains seven tables, each representing a different type of damage, as further defined in the revenue procedure: (1) total loss; (2) near total loss; (3) interior flooding over one foot; (4) structural damage from wind, rain, or debris; (5) roof covering damage from wind, rain, or debris; (6) damage to a detached structure; and (7) damage to decking. All seven tables detail a cost–indexed loss per square foot specific to the state or territory in which the taxpayer incurred the casualty.
Example 1: A taxpayer with a personal residence in Texas experienced a total loss of her 2,000–square–foot home from Hurricane Harvey. In computing the amount of her casualty loss, the taxpayer would use Table 1, “Total Loss,” of Rev. Proc. 2018–9, which provides a cost index per square foot for a medium–size personal residence of $195. Her loss would thus equal $390,000 (2,000 square feet × $195 per square foot).
By contrast, similarly situated taxpayers in the U.S. Virgin Islands would use a rate of $248 per square foot to measure the decrease in their homes’ FMVs. Note, however, that with respect to the U.S. Virgin Islands and Puerto Rico, this revenue procedure applies only to bona fide residents of the territories who otherwise have a U.S. income tax filing requirement.
On Dec. 22, 2017, Trump signed the TCJA into law, adding Sec. 165(h)(5) to the Code. This provision sharply curtails personal casualty losses that taxpayers may deduct in tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026.
Subject to the traditional limitations specified above, taxpayers may continue to deduct personal casualty losses, but only to the extent they are attributable to federally declared disasters (Sec. 165(h)(5)(A)). However, taxpayers with personal casualty losses not related to federally declared disasters may deduct those losses to the extent of personal casualty gains (Sec. 165(h)(5)(B)). If an excess casualty gain exists after application of the losses from casualties from other than federally declared disasters, taxpayers next apply any federally declared disaster losses against the remaining casualty gain (Sec. 165(h)(5)(B)(i)).
The following example illustrates the application of the new law.
Example 2: A married couple filing a joint return have a combined AGI of $75,000 in 2018. During the year, they are unlucky and experience multiple personal casualties: The wife’s uninsured wedding ring is stolen, resulting in a $17,500 casualty loss. As the result of a lightning strike, the taxpayers lose their home, but they have replacement–value insurance, resulting in a $15,000 taxable gain. Finally, the state in which they reside endures a federally declared disaster in which their car is destroyed, resulting in a $20,000 casualty loss.
Since the taxpayers experienced a personal casualty gain, they may offset it with a portion of their non—federally declared casualty loss. Specifically (but, for the purposes of this example, ignoring the Sec. 165(h)(1) per–casualty dollar limitation), the taxpayers would calculate their allowable loss for 2018 as shown in the chart below.
Calculating deductible casualty loss in Example 2
Example 3: By contrast, assuming the same facts as Example 2, except that the taxpayers endured the same calamities just a year earlier in 2017, and the federally declared disaster was Hurricane Harvey, the couple’s allowable loss would have been $15,000, composed of a $5,000 net disaster loss and a $10,000 casualty deduction, as shown in the chart below.
Calculating deductible casualty loss in Example 3
In tax year 2015, approximately 72,000 individual taxpayers claimed more than $1.6 billion in casualty losses, an average claim of almost $23,000 apiece (IRS Statistics of Income, Individual Income Tax Returns Line Item Estimates, 2015, pages 32 and 33). With the new limitations introduced in the TCJA, the availability of this deduction is severely diminished going forward. Practitioners may wish to highlight this change in communications with clients, perhaps also noting its implications for reviewing property insurance coverage.
Tax advisers should also be alert to IRS guidance in this area, including the definition of “attributable to a federally declared disaster” in new Sec. 165(h)(5). Notably, while the provision defines a “federally declared disaster” by reference to the definition in Sec. 165(i)(5), it does not specify that property must be within an area so designated for its damage or loss to be deductible. Sec. 165(i)(5)(A) defines a “federally declared disaster” as one determined by the president to warrant federal assistance under the Stafford Act. However, Sec. 165(i)(5)(B) specifies that a disaster area must warrant federal assistance for the rules to apply, so unless and until the IRS provides guidance otherwise, the prudent course would be to consider Sec. 165(h)(5) similarly constrained.
Taxpayers may also in some cases have a valid claim that the damaged property is connected with a trade or business or a transaction entered into for profit, rather than personal–use property, and thus be able to deduct a casualty loss under Sec. 165(c)(1) or (2), which continue to apply for casualties other than those attributable to federally declared disasters. However, tax advisers should advise them to make sure they can substantiate business or profit–seeking use of such property, especially where any apparent characteristics of personal use could render its status questionable by the IRS with respect to a casualty loss deduction not attributable to a federally declared disaster.
In these and other ways, by securing an available tax deduction, taxpayers can ameliorate unanticipated financial burdens associated with the occurrence of a casualty. While no one plans on suffering a casualty, through the passage of ad hoc legislation and the issuance of administrative relief, legislators and the IRS have repeatedly been responsive to such immediate hardships. If history is any indication of the future, it’s reasonable to expect that they will do so again.
About the authors
Kristie N. Tierney, MST, (firstname.lastname@example.org) is an instructor of income and corporate taxation; Jay A. Soled, J.D., LL.M., (email@example.com) is professor and director of Master of Accountancy in Taxation; and Leonard Goodman, CPA, Ph.D., (firstname.lastname@example.org) is professor and vice chair, Department of Accounting and Information Systems, all at Rutgers University in Newark, N.J.
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