Claiming a disaster loss.

How to avoid disastrous tax results following a disaster

From The Tax Adviser:

Claiming a Disaster Loss

M any Americans have lost property as a result of fire, floods, hurricanes or tornados. Although the tax treatment of such property is not the immediate concern of those affected, at some point the taxpayers must address and deal with the tax ramifications.

DISASTERS VS. OTHER CASUALTIES

A disaster is a casualty occurring in an area officially designated by the U.S. president as a disaster area entitled to federal assistance. This distinction is important: The rules governing disaster losses are different from those applicable to other casualty losses. While other casualties are deductible in the year they occur, a taxpayer who has suffered a disaster loss can elect to deduct that loss either in the year the disaster occurred or in the previous tax year.

DETERMINING THE AMOUNT OF THE LOSS

A taxpayer must first calculate the disaster loss and then determine whether there are limits on the amount that can be deducted.

The property loss must be due to actual physical damage caused by the disaster. An exception applies if the disaster causes a geographic area to be unsafe and the residents are ordered to relocate; under such circumstances, owners of unharmed residences in the unsafe area can claim a disaster loss deduction.

The loss attributable to personal- use property is the lesser of the decrease in the propertys fair market value attributable to the disaster or the decrease in its adjusted basis before the disaster. For individual taxpayers, this amount is then reduced by $100 (on a per-casualty basis) and a 10%-of-adjusted-gross-income threshold (which applies to the total net property loss for the year).

For property used by an individual as an investment or in a trade or business (including rents or royalties), the deduction is the loss less any amount recovered or recoverable by insurance. If the asset is completely destroyed, the loss is the propertys adjusted basis; if the property is merely damaged, the loss is the lesser of the decrease in the propertys fair market value or its adjusted basis.

The ability to deduct losses properly and accurately depends on being able to determine the value of the property before and after a disaster; therefore, adequate recordkeeping and documentation both before and after the disaster (such as photographs, videotapes, appraisals of property, estimates of repairs) is extremely important. As such, the Taxpayer Relief Act of 1997 provided that an appraisal made for the purpose of obtaining a federal loan or loan guarantee as a result of a presidentially declared disaster can be used (once guidance is issued) to establish the amount of a disaster loss.

REPORTING THE DEDUCTION

For business property, the disaster loss deduction is reported on Form 4684, Casualties and Thefts, and included on the individuals form 1040, line 14, as an above-the-line deduction. Any loss deductions for investment or personal-use property also are reported on form 4684 but must be included as miscellaneous itemized deductions on line 22 of schedule A on the 1040.

MAKING THE ELECTION

As noted, a disaster loss can be claimed in one of two tax years. To claim the loss, a taxpayer must file his or her return by the later of the due date (without extensions) of the return for the loss year or the extended due date of the return for the year immediately preceding the loss year; the return should specify the date of the disaster and the city, town, county and state in which the property was located.

If claiming the loss in the preceding year, the taxpayer can file an amended return and include a signed statement saying he or she elected to deduct the loss in the prior year.

WHICH YEAR TO DEDUCT THE LOSS

Deciding on the year in which to deduct the disaster loss is not simple. Although taking the loss on the previous years return provides an opportunity to obtain a quick refund, determining the “best” year in which to claim the loss should be based on many factors, including the difference in tax rates, capital gains vs. ordinary income treatment, the treatment of net operating losses (if any), the various adjusted gross income limits and thresholds, as well as the time value of money.

For a discussion of this election, see “The Complexities of the Sec. 165(i)(1) Disaster Loss Election,” by Dean Crawford, Diana Franz and Dennis Gaffney, in the October 1997 issue of The Tax Adviser.

—Nicholas Fiore, editor
The Tax Adviser