Navigating casualty losses no simple matter
Deducting casualty losses is never easy for disaster victims, and legislation in Washington has made it even more confusing this year.
On Oct. 2, President Trump signed a bill giving victims of Hurricanes Harvey, Irma and Maria special tax breaks, including a more generous personal casualty loss deduction. A bill in the House would give California wildfire victims the same benefits, but it hasn’t gone anywhere. The Trump administration has said they should get the same tax breaks.
Meanwhile, the House and Senate GOP tax overhaul bills would terminate the personal casualty loss deduction after this year, except for certain groups of people.
No matter what happens in Washington, people who lost their homes in the Wine Country fires can take the deduction if they qualify under the existing rules. However, some people who think they should get the deduction may not because of the way it’s calculated.
“It’s a mountain of work” to figure out, said Matthew Stockton, who lost his home near Santa Rosa and 40 years’ worth of possessions. “I have to go all the way to back to when we bought the house in 1990 (and calculate) what we paid for it, every improvement we’ve made over the years. It’s not as simple as it was worth this before the fire and this after the fire. I’m absolutely certain I’m going to extend my taxes. There is no way I’ll be done in April. I might not be done in October.”
Under current law, you can
deduct unreimbursed personal casualty and theft losses as an itemized deduction on your tax return. Casualty losses result from any “sudden, unexpected or unusual event” such as a hurricane, fire or earthquake. If the loss was the result of a major, presidentially declared disaster, you can take it in the year the loss occurred or the previous year (by filing an amended return). Otherwise, you generally take it in the year it occurred.
The loss is defined as the lesser of your adjusted cost basis in the property or the decrease in its fair market value — minus any salvage value, insurance and other reimbursements. Here is a very simplified example. Disaster victims should consult a wellqualified tax expert.
In the case of a house, your basis is usually what you paid for the house, plus any additions or major improvements. If you bought your house five years ago for $500,000 and added a $100,000 master suite, your basis is $600,000.
The change in fair market value is what the property was worth the day before the disaster minus what it was worth after. If the same house was worth $1 million before the fire and it’s gone, your decrease in market value is $1 million.
In this example, your casualty loss is $600,000 because it’s less than $1 million. (For simplicity, this example excludes the land value.)
The same rule applies to your personal property. Suppose you bought a couch five years ago for $1,000. That’s your cost basis. The day before it went up in flames, it would have sold for $500 on Craigslist. That’s its pre-fire market value. Your casualty loss is $500 because it’s less than $1,000.
Next, you add up all your casualty losses, then subtract your actual and expected insurance proceeds. If your losses total $700,000 and you expect to receive $600,000 in proceeds, your loss is $100,000 — but that’s still not the amount you can deduct.
If your property was for personal use, you also must subtract $100 (don’t ask why) and 10 percent of your adjusted gross income the year you are taking the deduction. (These two subtractions don’t apply to any property used in a business, including a home office.)
If your adjusted income is $120,000 and you had no business property, you would subtract $12,100 from your $100,000 loss, leaving you with an $87,900 itemized casualty loss deduction. If you take the standard deduction, you cannot take this, although a loss this large would make itemizing worthwhile. (Note: Your casualty loss cannot exceed your income that year.)
Thanks to HR3828, victims of Hurricanes Harvey, Irma and Maria do not have to subtract 10 percent of their income from their casualty loss; they can deduct 100 percent of it. And they can take this deduction even if they don’t itemize; they can add it to their standard deduction. However, instead of subtracting $100 from their loss, they must subtract $500. This law provides other tax relief for hurricane victims, including an exemption from the 10 percent penalty for early retirement-plan withdrawals.
HR4397, sponsored by 19 Democratic and Republican representatives from California, would give wildfire victims the same tax benefits hurricane victims are getting.
“For some people in our area, this potential rule change is very impactful. For others, it sounds great but it’s not that big of a deal,” said David Dillwood, a Santa Rosa CPA.
Many fire victims won’t be able to deduct a casualty loss because their insurance proceeds will exceed the lesser of cost basis or pre-fire market value. For those who can, not having to subtract 10 percent will help a lot because incomes here tend to be high, Dillwood said.
Instead of a casualty loss, some disaster victims could actually have a gain. This can happen if your insurance proceeds exceed the lesser of cost basis or loss in fair market value. This gets very complicated, but you generally won’t owe tax on this gain if you use your insurance proceeds to rebuild or replace what you lost or if you qualify for the capital gains exclusion on a primary residence, said Michael Gray, a San Jose CPA.
In the eight California counties covered by the president’s fire disaster declaration, people can claim a loss on their 2017 or 2016 returns. “The loss must account for a reasonable prospect of recovery from insurance or a third party,” such as a company you are suing, said Nathan Rigney, lead tax research analyst at the Tax Institute at H&R Block.
Some fire victims claiming a casualty loss will have to estimate their insurance recovery. If it ends up being less or more than estimated, they generally will have to include the difference on their tax return the year it is received.
It’s not clear how people suing PG&E for uninsured losses from the fire would account for any potential recovery if they wanted to claim a casualty loss. Although no cause has been determined, at least 32 lawsuits allege the utility’s failure to trim trees around its power lines sparked the fires.
“If there was a reasonable prospect of recovery from PG&E, that possible recovery would have to be deducted from any casualty loss claimed in 2017,” said Mark Luscombe, principal analyst with Wolters Kluwer. “If the litigation involves a sufficient amount that there would be no casualty loss if there was a full recovery, then no casualty loss can be claimed until the litigation is resolved,” he said in an email.
Whether there is a “reasonable prospect of recovery” from PG&E is an “open question,” Rigney said.
If homeowners suing PG&E can’t claim a casualty loss on their 2017 or 2016 return because they expect a recovery but don’t get one, they might not be able to claim it in future years if Congress does away with the deduction.
The tax overhaul bill passed by the House would eliminate the personal casualty deduction after 2017, except for victims of Hurricanes Harvey, Irma and Maria. (It’s not clear why they would need it after this year unless they discover mold next year.) The Senate version would eliminate the deduction after this year except for victims of presidentially declared disasters.
For more information, see IRS Publication 547 and a tax pro.