As part of ThinkAdvisor’s Special Report, 23 Days of Tax Planning Advice: 2016, throughout the month of March, we are partnering with our ALM sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.

1. What is a casualty loss?

A casualty loss is a loss that an individual taxpayer suffers as a direct result of an event that meets the following criteria:

  1. It is identifiable;
  2. It is damaging to property; and
  3. It is sudden, unexpected and unusual in nature.

IRC Section 165 specifically permits a casualty loss deduction for fire, storm, shipwreck or “other casualty.” The term “other casualty” has been interpreted to include damage sustained as a result of, among other events, floods and sudden freezing. Other deductible casualty losses that are specifically allowed by the IRS include damage caused by fire, earthquake, government ordered demolition or relocation of a home rendered unsafe due to a disaster, mine cave-ins, shipwrecks, sonic booms, storms, terrorist attacks, vandalism and volcanic eruptions.

The Tax Court allowed a taxpayer’s casualty loss deduction for damage caused by blasting operations when the damage caused by the particular blast was unusual and heavier than the blasting that had occurred on a day-to-day basis in the area. The Tax Court has also permitted a casualty loss deduction for damage sustained due to vandalism, because the vandalism in question was caused by persons outside of the taxpayers’ control, was sudden in nature and destructive in effect.

Damage to property created by termite infestation was not considered to be a casualty loss, because the damage was created by a progressive deterioration of property resulting from a steady cause operating over time—essentially, the casualty loss deduction was denied because the event that caused the destruction was not “sudden” in nature.

A taxpayer was not entitled to claim a casualty deduction for losses sustained as a result of the worthlessness of currency held by the taxpayer. The Tax Court found that “other casualty” must be interpreted to mean an event similar to “fire, storm or shipwreck” and that a decrease in currency value was not a similar event. Further, the Court noted that the taxpayers actually still held the currency at issue—and thus, it was not technically damaged.

Further, costs incurred by a taxpayer in order to prevent a potential casualty loss are not deductible under IRC Section 165 as casualty losses. According to the courts, such preventative steps are not sudden and unexpected in nature, and thus do not qualify as events giving rise to casualty loss treatment.  Generally, casualty losses are deductible during the taxable year that the loss occurred

2. What is a theft loss?

A theft loss is a loss sustained as a result of (among other things) larceny, embezzlement or robbery. The taking of property must be illegal under the law of the state where it occurred and it must have been done with criminal intent. A conviction does not need to occur, however, to show a theft loss.

The definition of “theft” is given a broad meaning and, therefore, a theft loss deduction may often be allowed in situations that do not involve the straightforward theft of property. For example, the IRS has allowed a theft loss deduction when a publicly-traded company misrepresented its financial condition in a business transaction in which the company traded its common stock in a tax-free reorganization and that stock subsequently became worthless. The IRS analogized the situation to “larceny by false pretenses” in that the company’s officers knew that their representations were false.

In a revenue ruling, the IRS held that a theft occurred when a taxpayer’s employee pledged shares of the taxpayer-employer’s stock as collateral to secure a personal loan. When the bank later sold the stock, the taxpayer-employer was able to treat the property as stolen, and the proceeds obtained in the employer’s settlement of the lawsuit against that employee were considered proceeds obtained as a result of an involuntary conversion.

The decline in the market value of stock is not deductible as a theft loss where the stock is acquired on the open market if the decline is caused by accounting fraud or other illegal misconduct by the officers or directors of the corporation that issued the stock. However, the loss sustained when stock is sold or exchanged, or becomes completely worthless, is deductible as a capital loss reportable on Schedule D of Form 1040.

3. How is the amount of a taxpayer’s allowable casualty or theft loss deduction determined?

If a taxpayer has suffered a casualty (or theft) loss, regardless of whether the loss is personal in nature or is related to trade or business activities, the taxpayer may be entitled to deduct the lesser of the following amounts:

  1. The fair market value immediately before the casualty minus the fair market value of the property immediately after the casualty; or
  2. The adjusted basis of the property that would be used for determining the taxpayer’s gain or loss if the property was sold or otherwise disposed of.

Planning Point: Although the regulations use the term “immediately after” when referring to the post-casualty value, the IRS recognizes that taxpayers’ ability to determine the decrease in the fair market values of their properties, as a result of a disaster, may be restricted by lack of access to the properties and the need to remove water from flooded properties. Under these circumstances, the decrease in fair market value would take into account additional damage sustained to the property as a result of delays due to legal and physical restrictions to taxpayers’ access to their property and the need to remove standing water from the properties.

The fair market value of the property must be ascertained by appraisal, and this appraisal must consider the impact of any general market decline affecting undamaged property (as well as damaged property) that may have occurred at the same time as the casualty, so that the casualty loss is limited to the actual loss caused by the casualty.

The taxpayer claiming the casualty loss may use the actual cost of repairs to the property as evidence of the amount of loss if the following conditions are met:

  1. The repairs are necessary to restore the property to its condition immediately before the casualty;
  2. The cost of the repairs is not excessive;
  3. The repairs only fix the damage suffered as a result of the casualty; and
  4. The repairs do not cause the value of the property to exceed the value of the property immediately before the casualty.

The cost of repairs may, in certain cases, be used to measure the decline in fair market value, but it cannot be used by itself to determine the amount of the loss. When the cost of repairs is determined to be a fair measure of the decline in fair market value, then the fair market value of the property before the casualty is reduced by the cost of repairs to arrive at the fair market value after the casualty.

If the property at issue was used in a trade or business (or otherwise held for the production of income) and was totally destroyed by the casualty, the taxpayer may use the adjusted basis to determine the amount of loss if the fair market value of the property immediately before the casualty is less than the adjusted basis.

When property used in a taxpayer’s trade or business (or otherwise held for profit) is destroyed, each single, identifiable piece of property must be considered separately in computing the amount of loss.

Example: Chase owns a marina comprised of a large storage building and a boat docking area. The marina is badly damaged in a hurricane. In determining the fair market value of the property for purposes of determining loss, Chase must measure the decrease in value by taking the building and the docks into account separately, rather than together as two integral pieces of the property as a whole. In other words, he must determine the losses separately for the building and the docks.

However, where separate property is considered to be an integral piece of the property as a whole (for example, ornamental trees and shrubs on residential property), no separate calculation is made.

4. When is a taxpayer entitled to take a deduction for a theft loss?

A taxpayer who sustains a theft loss may take the deduction for the tax year in which the taxpayer discovers the loss, rather than the year in which the loss was sustained (as is the general rule for casualty losses).

The reasonable prospect of recovery doctrine applies in the case of theft losses, so that the taxpayer will not be entitled to take a deduction if there is a claim for reimbursement against a third party that may fully or partially compensate the taxpayer for the theft loss, and there is a reasonable prospect that the taxpayer will recover these amounts. These rules do not apply to a theft loss discovered through a shortage in the inventories of a business.

The amount of the taxpayer’s theft loss deduction is determined using the same method applicable to casualty loss deductions:

Example: Denise purchased a watch for $15,000 in 2012. In 2015, the watch, which now has a fair market value of $13,500, is stolen. Denise does not discover that the watch is missing until 2016. Though the watch was insured against theft, the insurance company challenges its liability for the loss. Despite this challenge, Denise has a reasonable prospect of recovering from the insurance company in 2016. In 2017, Denise settles with the insurance company and receives $12,000 in insurance proceeds to cover the theft loss. Denise is not permitted to take a deduction in 2015 or 2016, but in 2017, she is permitted a theft loss deduction for $1,500. The computation is made as follows:

Value of property immediately before theft

$13,500

Less: value of property immediately after theft

$0

Balance

$13,500

Loss to be taken into account for purposes of Section 165(a)

$13,500

Less: insurance received in 2017

$12,000

Deduction allowable for 2017

$1,500

 

See ThinkAdvisor’s complete tax planning home page: 23 Days of Tax Planning Advice: 2016.