Understanding Casualty Loss Deductions and Distributions from Tax-Qualified Retirement Plans and IRAs in Federally Declared Disaster Areas

Synopsis 

Casualty Defined

Generally, casualty losses are losses, damage or destruction of property caused by fire, theft, vandalism, earthquake, storm, floods, terrorism, or some other sudden, unexpected or unusual event. While, the rules are slightly different for individuals and businesses, IRC Section 165 generally provides a deduction for losses that are not covered by insurance or other reimbursement. In addition, special casualty loss rules apply to losses in federally declared disaster areas.  

A disaster loss is a loss attributable to a casualty occurring in an area that the President declares as a disaster area and entitled to federal assistance under the Disaster Relief and Emergency Assistance Act. In the aftermath of a major disaster, determining assets that were lost or damaged, the original cost, tax basis, and fair market value (FMV) of those items, and documenting the loss(es) is a major hurdle.  If you are looking to document casualty losses, the IRS maintains a Record Reconstruction page to assist taxpayers with reconstructing their records after incurring a casualty loss, which may be helpful to you.

Determining the Amount of the Casualty Loss

A casualty loss is calculated by subtracting any insurance or other reimbursement received or expected from the lesser of:

• The decrease in FMV of the property as a result of the casualty, or
• The adjusted basis in the property before the event

FMV is defined as the price that a willing buyer would pay to a willing seller, when there is no requirement to sell the property, and both parties know all the relevant facts.  The decrease in FMV used to figure the amount of a casualty loss is the difference between the property’s FMV immediately before and immediately after the casualty event.  To determine the decrease in FMV as a result of a casualty, a taxpayer generally requires a competent, independent appraisal. Reliable appraisals of the value of the property immediately before and after the casualty are generally regarded as the best evidence for a decline in value, but for many taxpayers, it can be difficult (or impossible) to get a qualified appraisal of the pre-casualty value after the casualty event.

The adjusted basis of property is usually the taxpayer’s original cost in the property, increased or decreased by certain events such as improvements or depreciation. 

Example: Assume that a taxpayer lost her home and all of its landscaping from a storm and will not receive any insurance proceeds relating to the casualty.  The basis of the residence, which includes the cost of the landscaping, is $700,000. The fair market value of the home and landscaping before the storm was $800,000 and after the storm was $0. The cost to remove the damaged trees and replant is $25,000. For purposes of determining the amount of the loss, only the adjusted basis of $700,000 and the loss in value of $800,000 are considered since the landscaping was part of the fair market value of the home. Accordingly, the casualty loss here is $700,000 (the lesser of basis ($700,000) or FMV before the event ($800,000), as compared to the FMV after the event ($0)).

Proof of Loss

To deduct a casualty loss, a taxpayer must prove that there was a casualty and must also be able to support the amount taken as a deduction. For a casualty loss, a taxpayer should be able to show and prove the following:

• The type of casualty and when it occurred;
• The loss was a direct result of the casualty;
• The taxpayer was the owner of the property or, if the loss property was leased property, there was a contractual liability to the owner for the damage; and

A claim for reimbursement exists for which there is a reasonable expectation of recovery

Forms to File

Casualty losses are generally reported on IRS Form 4684, Casualties and Thefts. However, the rules for determining the amount of the deductible loss and where the loss is reported on the income tax return vary depending upon whether the loss is business property, investment property, or personal-use property. Accordingly, Schedule A (Form 1040 or 1040NR), Schedule D, Schedule E, and/or Form 4797, Sale of Business Property, may be required depending on the type of property involved. 

When to Claim the Loss Deduction

Casualty losses are generally deductible in the year the casualty occurred. If a taxpayer has a casualty loss arising from losses in a federally declared disaster area, however, the taxpayer can elect to treat the casualty loss as having occurred in the year immediately preceding the tax year in which the disaster occurred, by including a signed statement in the tax return filed claiming the casualty loss, that the taxpayer elects to deduct the loss in the prior year.  This deduction can be claimed on an original or amended return for the preceding tax year. 

The election to take the deduction in the earlier tax year must either be made on or before:

• The later of the due date for filing the income tax return, without considering any extensions, for the taxable year in which the disaster actually occurred; or
• The due date for filing the income tax return, including extensions, for the taxable year immediately preceding the taxable year in which the disaster actually occurred.

To claim casualty losses incurred in 2017 as a deduction on a taxpayer’s 2016 return, the election must be made by April 15, 2018.  This is because the due date to make this election was extended by 6 months for declared disaster areas.

Deduction Limits

After a loss has been computed, the deductible amount must be determined. If the loss was property held for personal use, there are two limits on the amount deductible:

• Each casualty loss must be reduced by $100 (so if a taxpayer had more than one casualty, each loss must be reduced by $100) and
• Reduce the loss by 10% of the adjusted gross income. 

Example: A taxpayer is located in a federally declared disaster area and the taxpayer’s home and furniture were destroyed by a hurricane in 2017. This is the only casualty loss for the year. The cost of the home and land was $134,000.The FMV immediately before the disaster was $147,500 and the FMV immediately after the disaster was $100,000. The taxpayer determined that she had a total loss for furniture of $3,000. The taxpayer does not expect any reimbursement for the home or furniture. The taxpayer elects to amend her 2016 return to claim the casualty loss for the disaster.  The taxpayer’s adjusted gross income (AGI) on the 2016 tax return was $71,000.  The casualty loss is determined as follows:

Casualty Loss Deductions for Insured Property

Taxpayers may claim a deduction for damage to insured property, but only if a timely insurance claim has been filed.  Any loss actually sustained during the taxable year and not compensated by insurance or another form of compensation is allowed as a deduction. A taxpayer may not deduct the portion of the loss with respect to which there is a reasonable prospect of recovery.  Therefore, in determining the amount of the deduction, taxpayers must determine whether there is a reasonable prospect of recovery.

Casualty Loss Reimbursements Could Trigger Gain

Insurance reimbursements can also trigger a capital gain.  For example, a taxpayer has a capital gain if they receive a reimbursement exceeding the adjusted basis in the destroyed or damaged property.  In order to calculate any gain, the taxpayer would subtract the adjusted basis in the property at the time of the casualty event from the reimbursement amount. 

A taxpayer may postpone reporting the gain on damaged or destroyed property if the taxpayer reinvests in property that is similar or related in service or use to the damaged or destroyed property within a specified replacement period, which is typically two years from [when – the date of reimbursement, date of loss??  If postponed, when will the gain be reported??]. If the amount of the reimbursement exceeds the adjusted basis in the damaged or destroyed property, and the taxpayer does not reinvest the insurance proceeds in a similar property, a taxpayer must include the excess amount of income in the year the reimbursement is received.  As noted below, there are special rules relating to “gains” arising from casualties in federally declared disaster areas.

Special Rules for Involuntary Conversion Gains in Federally Declared Disaster Areas

As noted above, generally, pursuant to IRC §1033(a), if property is destroyed as a result of a storm, no gain will be recognized if the destroyed property is converted into similar property within two years. If the property is converted into money or dissimilar property, however, the gain generally will be recognized. The “similarity” requirement is measured by use or service of the destroyed property.

IRC §1033(h) provides the following special rules for property damaged in a federally declared disaster:

• There is a four-year replacement period for destroyed property.
• For personal property (meaning, not buildings), there is no taxable gain from insurance proceeds that cover losses for personal property that was not itemized on the homeowner’s insurance policy.  (IRC §1033(h)(1)(A)(i))
• Insurance proceeds for the residence and any scheduled personal property may be combined together and treated as the conversion of a single item of property.  Additionally, replacement property consisting of a building and personal property are considered a single item and also will be similar in use to the damaged or destroyed principal residence. This means a taxpayer will not be required to prove whether the insurance proceeds received for a specific item were reinvested in similar or related property, because the reimbursement is treated as a common pool of funds.
• Any tangible personal property held for productive use in a trade or business is treated as property similar in use to the converted property. See IRS Technical Advice Memorandum 201111004. This provision allows a business to take funds from involuntarily converted inventory and apply those funds towards other tangible business property for which it has a greater need.

Example: A taxpayer receives an insurance reimbursement in 2015 for $100,000 after the taxpayer’s principal residence is destroyed by an earthquake. The taxpayer expects to receive an additional $150,000 in 2016. The taxpayer lives in a federally declared disaster area. The FMV of the home was $500,000 before the earthquake and $200,000 immediately thereafter. The taxpayer’s adjusted basis in the property is $140,000, and the taxpayer will spend $175,000 to replace the destroyed home but will use the remaining cash from insurance to pay down her mortgage.  Based on the preceding, will the taxpayer have a gain or loss?
Here, the taxpayer will have a gain of $75,000, the excess of insurance proceeds over the cost to restore the property.  The pay down of the mortgage is not considered a reinvestment of the insurance proceeds.

Here, the taxpayer will have a gain of $75,000, the excess of insurance proceeds over the cost to restore the property.  The pay down of the mortgage is not considered a reinvestment of the insurance proceeds.

Net Operating Losses

IRS Advice to Taxpayers in Federally Declared Disaster Areas

• Taxpayers in federally-declared disaster areas may use a special toll-free number ((866) 562-5227) year-round for information to speak with an IRS specialist.
  Many financial institutions provide paperless statements and documents that can be assessed online. Even if the original document is in paper form, taxpayers should scan these documents, save them into an electronic format, and store them on an external hard drive, USB flash drive, burn a CD, or DVD.
• Taxpayers can request back copies of previously filed tax returns and attachments, including W-2 forms, by filing Forms 4506, Request for Copy of Tax Return.  Also, transcripts showing most line items on returns can be ordered via the Get Transcript link on IRS.gov, by calling 800-908-9946, or by using Form 4506-T-EZ, Short Form Request for Individual Tax Return Transcript, or Form 4506-T, Request for Transcript of Tax Return.
• The IRS has a disaster loss workbook, Publication 584, to assist taxpayers in assembling room-by-room lists of their property.

Use of Funds from Tax-Qualified Retirement Plans and IRAs to Rebuild

In the context of presidentially-declared disasters such as tornadoes, hurricanes, wildfires, flooding, and earthquakes, the IRS has a long history of providing a broad range of plan sponsor and plan participant relief in connection with the impact of the disaster on the operation of tax-qualified retirement plans and IRAs. Soon after such a disaster is declared, the IRS issues a news release detailing the type of relief (e.g., the postponement of an otherwise deadline), the persons entitled to the relief (those who live in or have a business in an area directly impacted by the disaster), and the duration of the relief period. In particular, Section 8 of IRS Revenue Procedure 2007-56 lists the tax-qualified retirement plans and IRAs deadlines that may be postponed on account of a disaster. These include:

• Plan loan repayment requirements under IRC Section 72(p).
• In certain scenarios, avoiding the 10% additional tax under IRC Section 72(t).
• Timely elections under Section 83(b).
• Timing requirements for IRA contributions.
• Timing requirements for tax-free rollovers.
• Certain ESOP requirements.
• Avoiding the 10% tax on nondeductible contributions under IRC Section 4972.
• Avoiding the 50% tax on failures to make required minimum distributions under IRC Section 4974.
• Avoiding the 10% tax on excess contributions under IRC Section 4979.
• Form 5500 (Annual report) filings.

Timing requirements for certain voluntary corrections.

The IRS recently announced certain relief measures for tax-qualified retirement plans (Sections 401(a), 401(k), 403(b), 457(b)) and IRAs in connection with Hurricanes Harvey, Irma and Maria. In particular, until January 31, 2018, such plans will be able to provide hardship distributions and plan loans to affected participants under special relaxed rules. These include:

• Hardships arising under Hurricane Harvey or Irma will qualify as eligible for hardship distributions (including hardships experienced by certain family members) regardless of whether they meet the otherwise applicable “unforeseeable emergency” requirements.
• Waiver of the otherwise 6-month moratorium on plan contributions for recipients of hardship distributions.

• Permitting certain loans and hardship distributions to be made before all of the otherwise required documentation is in place.
• Permitting plans to make loans and hardship distributions even where the terms of the plan do not provide for them (plans must be amended to so provide, generally by December 31, 2018).

In addition, any affected plan otherwise required to file its Annual Report (Form 5500 series) between August 23, 2017 and January 31, 2018 (if affected by Hurricane Harvey) or between September 4, 2017 and January 31, 2018 (if affected by Hurricane Irma), will have until January 31, 2018 to do so.

What Does CohnReznick Think?

Contact

For more information, please contact Richard Shevak, Principal, National Tax Services, at Richard.Shevak@CohnReznick.com or 862-245-5029.

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