Personal Casualty Losses

Taxpayers have long been able to deduct personal casualty losses as an itemized deduction on their individual income tax returns. However, for many years, most taxpayers have not been able to benefit from these provisions because of two specific limitations. First, the casualty loss amount had to exceed $100, and second, the amount deductible was further limited by an amount equal to 10% of the taxpayer's adjusted gross income. For example, if the taxpayer had a $9,000 personal casualty loss and their 2004 adjusted gross income (AGI) was $75,000, the deductible amount would be $1,400. The $9,000 would be reduced by $100 leaving $8,900 and this would be subject to a $7,500 AGI limitation thus leaving $1,400 deductible.

KETRA has changed this by removing the two limitations on any losses that arose from hurricanes Katrina, Wilma or Rita on or after Aug. 24, 2005, in the disaster area. These losses are reported by an individual taxpayer as an itemized deduction on Schedule A of Form 1040, with the details reported on Form 4684.

Since this was a presidentially declared disaster, the casualty losses incurred after Aug. 25, 2005, can be reported on either the 2005 individual return or the taxpayer can elect to report the loss in the year immediately preceding the taxable year, 2004. Normally taxpayers would have until April 15, 2006, to make this election. However, the IRS has announced that the extension to make the election is until Oct. 15, 2006. Thus, the taxpayer can determine if it is better to amend the 2004 return and get an immediate refund or take the loss on 2005 and reduce the current year taxable income. The decision to do this should be based on the taxpayer's marginal tax bracket in each year and also when they plan to file their 2005 returns.

The actual determination of the amount of the casualty loss can be a fairly complicated computation. The amount of the loss is figured by subtracting any insurance or other reimbursable amounts received from the lesser of the decrease in fair market value of the property as a result of the casualty or the adjusted basis of the property before the event.

How do you determine a decrease in fair market value? The taxpayer must make a determination of the actual price for which property could have sold immediately before and immediately after the casualty. Typically, reliable appraisals of the value of the property immediately before and after would be regarded as the best evidence in the decline of value. The tax laws do not let you consider any of the following items in establishing the fair market value of the property:

• Sentimental value
• General decline in market value
• Repair and replacement cost

However, the cost of cleaning up and making repairs can be used as a measure of the decrease in fair market value if all the following conditions are met:

• Repairs are necessary to bring the property back to its condition before the casualty
• The amounts spent for the repairs are not excessive
• Repairs take care of the damage only
• The value of the property after the repairs is not, due to the repairs, more than the value of the property before the casualty

There are many misconceptions about the cost of restoring landscaping. Often, landscapers and others will give a taxpayer a value of what a tree, shrub or yard may have been worth. But, usually that evaluation alone will not be sufficient to determine value. The cost of restoring landscaping to its original condition may also be an indication of the decrease in the fair market value. A taxpayer might be able to measure the loss by the amounts spent on the following:

• Removing destroyed or damaged trees or shrubs,
• Pruning and other measures taken to preserve damaged trees and shrubs
• Replanting necessary to restore the property to its approximate condition before the casualty

Keep in mind that the casualty loss is the smaller of this value or the basis in the property destroyed. Insurance or other reimbursements must be subtracted from the tentative loss whether it is a decrease in fair market value or the adjusted basis. No casualty loss is allowed to the extent that it is reimbursed. If the reimbursement exceeds the tentative loss, the taxpayer may have taxable income from the casualty.

If the taxpayer faces a gain from excess reimbursements over their tentative loss, they can still avoid reporting the gain by reinvesting the proceeds in substitute property within five years.

Insurance proceeds for the residence and any scheduled personal property can be lumped together and treated as conversion of a single item of property. This treatment effectively allows taxpayers to replace their home and contents with items of their choosing, not restricting them to replacement with artwork, etc.

Example

Mr. Smith's principal residence and all its contents were destroyed by Hurricane Katrina. Destroyed household contents included jewelry and sterling silver, each of which was separately scheduled for insurance purposes. Mr. Smith received total insurance proceeds of $310,000 ($300,000 for residence, $7,000 for jewelry and $3,000 for silverware). Common pool of funds = $310,000. Mr. Smith spent $300,000 for new residence, $40,000 to purchase home furnishings and clothing and $10,000 for a new painting. He did not replace the jewelry or silverware.

Because Mr. Smith spent $350,000 to purchase a replacement residence and contents (in excess of the $310,000 of common pool of funds he received), Mr. Smith will not be required to recognize any gain upon the destruction of the residence and its contents.