Every year natural disasters like hurricanes strike repeatedly, affecting tens of thousands of Americans. Fortunately, individuals whose homes, household goods and other properties are damaged or destroyed by such disasters can count on a helping hand from their uncle--Uncle Sam, that is. Internal Revenue Code Section 165 authorizes immediate relief in the form of deductions for casualty or theft losses. The IRS defines qualifying losses as those caused by identifiable events that are "sudden, unexpected or unusual."
This includes hurricanes, fires and floods as well as a lengthy list of other unpredictable misfortunes such as auto accidents, earthquakes, landslides, lightning, riots, sonic booms, storms, terrorist attacks, tornadoes, tsunamis, vandalism and volcanic eruptions. Then there are losses from theft--a category of offenses that includes burglaries, extortion, embezzlement, robberies and swindles.
The IRS stands ready to partially ease the pain for those who suffer serious property damage. The agency allows them to write off uninsured losses on their returns, but the permissible write-off is shockingly smaller than many disaster survivors anticipate.
For starters, long-standing regulations generallyprohibit any write-offs for theft or casualty losses suffered by individuals who use the standard deduction. Onlytaxpayers who itemize on Form 1040's Schedule A are eligible for tax relief. Even then, deductions for casualty or theft are subject to several limitations.
?First, file claims and account for settlements. The IRS requires individuals to reduce their losses by anyinsurance settlements or other reimbursements they have received or expect to receive. They also must do without any deductions if they fail to file claims. It matters not that submitting claims might provide their insurers with excuses to boost deductibles, increase premiums or even cancel coverage. However, the IRS does concede that write-offs are allowable for amounts not covered byinsurance, including deductibles.
?Second, subtract $100 per loss. The agency usually mandates another subtraction of $100 for each loss. But it orders only one $100 reduction when the same event damages several items, for example: The same flood damages a person's home and detached garage or a year-round home and a summer cottage. The same is true when a hurricane damages a person's dwelling twice--e.g., first by winds and then by high waves.
?Third, losses must exceed 10 % of AGI. Uninsured losses generally are allowable only to the extent that their total exceeds 10% of adjusted gross income. Just how much of a deduction is allowable, then, when someone suffers losses of $20,000 after insurance recoveries, and their AGI is $100,000? It shrivels to just $9,900--$20,000 minus $100 minus $10,000 (10% of AGI).
The $100 and 10% limitations do not apply to casualty or theft losses of business property or investment property such asrental real estate. Those categories of losses are fully deductible.
On the other hand, there is no write-off for incidentalexpenses relating to casualties or thefts such as temporary lights, fuel, moving, rentals, legal fees, towing charges, and the care of personal injuries.
Relaxed Rules for National Disasters
Tax code changes enacted in October of 2008 eliminate or modify several restrictions on deductions allowed victims of all federally-declared disasters that occur during 2008 and 2009. These revisions--tucked into the Emergency Economic Stabilization Act of 2008--allow disaster victims to claim their entire loss, not just the portion that exceeds 10% of AGI. Under the new rules, the $100 floor increases to $500. And no longer is tax relief available only for individuals who itemize on Schedule A. Even if they choose to use the standard deduction, they still can claim disaster losses.
The paperwork to submit refund claims for disaster losses is not burdensome. Form 1040X can amend a prior year's return without complicated red tape. It merely asks for an explanation of the loss (the figures go on an accompanying Form 4684) and computation of the refund due. Include specificinformation about the time, place and nature of the disaster that caused the loss. To speed up processing of the refund, the IRS recommends putting the disaster designation prominently in red ink at the top of the 1040X, with a notation such as: "Louisiana disaster area claim--Hurricane Ike."
Net Operating Losses
Special rules apply when a casualty or theft loss deduction is more than the victim's entire income for the year of loss, and no tax is paid. If this is the case, check whether he falls under the often overlooked carry-back and carry-forward provisions of the rules for net operating losses (NOLs). The law does not require that you be in business to have a NOL from a casualty or theft. The excess loss can be used to recover or reduce taxes paid in other years. The personal NOL rules allow an unused loss to be taken as an additional deduction for the three prior years--versus only two for a business NOL--and then for the 20 following taxable years. Note that the 2008 law changes increase the carry-back to five years for federally-declareddisasters that occur during 2008 and 2009. Alternatively, you can elect to forego the entire carry-back and just carry forward the excess amount for 20 years until it is used up. As a general rule, the election will be advisable if a greater tax savings results from a carry-forward rather than a carry-back.
More Complex Cases
When it comes to casualty losses, there are lots of otherwrinkles. For instance, a husband and wife who plan to deduct a casualty loss need to ascertain whether they jointly or separately own the damaged property and whether one of them will declare more income than the other. Those are among the circumstances that bear on their decision to file joint or separate returns. The only way to determine the best strategy is to crunch the numbers both ways.
IRS Audits: Guilty until Proven Innocent
These are basically adversarial proceedings and the deck is stacked in favor of the agency. Unlike criminal trials, where defendants are presumed to be innocent until the government establishes their guilt, the burden of proof in tax disputes is on taxpayers. So expect the agency's examiners to ask someprobing questions about lost or damaged possessions.
The IRS strictly defines casualty losses. It prohibits deductions for damage or loss that stems from natural action, such as termite damage or gradual deterioration of property caused by normal weather conditions.
For instance, an IRS ruling barred a casualty-loss deduction for squirrel damage. Holes in a roof caused by squirrels were not "unexpected" and "unusual" events, according to ruling 8133097, which also noted "it is common knowledge that squirrels are destructive."
Julian Block, an attorney based in Larchmont, N.Y., conducts continuing education courses for financial planners and other professionals. Information about his books is at www.julianblocktaxexpert.com.