Much of the Gulf Coast and Eastern Seaboard are still in the Atlantic hurricane season. In light of the disastrous impact that Hurricane Dorian had in the Bahamas and parts of the Southeastern United States late in August, in addition to wildfires, tornadoes and severe floods that have wreaked havoc across much of the country throughout the summer, many clients likely have questions about post-disaster options, from a tax perspective, whether they have already been impacted or simply worry about future events.
Importantly, the rules for deducting expenses associated with casualty and disaster losses post-reform are not as clear-cut as those that applied prior to implementation of the 2017 tax reform legislation. Clients now must understand both the complexities that have always existed in claiming the casualty loss deduction and those associated with changes made by the new tax law.
Post-Tax Reform Casualty Loss Deduction
Prior to tax reform, most victims of natural disasters were entitled to take a federal tax deduction for losses that were not reimbursed by insurance. However, under current law created by the 2017 tax reform legislation, individual taxpayers are no longer entitled to a general deduction for casualty loss expenses (assuming that those losses were not related to property used in a trade or business). Despite this, the new law contains an exception for certain federal casualty losses, meaning those that occur in federally-declared disaster areas.
Additionally, if a taxpayer has personal casualty gains, the new rules do not apply (even if the loss does not occur in a federal disaster area) so long as the losses do not exceed the gains. This essentially means that casualty losses can be used to offset casualty gains even post-reform.
Because of these new rules, if a taxpayer sustains losses in a natural disaster, the client should first be advised to check the FEMA website to determine whether the federal government has declared a federal disaster in the area where their property was located. Even if the disaster does occur in a federally-declared disaster area (as many major disasters do), the client will still be required to itemize deductions on Schedule A in order to claim the deduction—meaning that total itemized deductions must exceed the relatively high $24,400 per-married couple ($12,200 per individual) standard deduction post-reform.
Mechanics of the Post-Tax Reform Casualty Loss Deduction
To itemize the casualty loss deduction, the client will need to include the FEMA disaster declaration number on Form 4684 and attach that form to his or her federal income tax return for the year. Section A of the form deals with personal casualty losses, while Section B is where the client reports any business casualty losses.
Determining the value of the casualty loss deduction begins with determining whether the property was income-producing (business-related) property or personal property. The value of the casualty loss deduction for business property is generally the adjusted basis of the property (i.e., the price paid plus the value of any substantial long-term improvements, minus depreciation claimed), assuming that the property was completely destroyed.
For personal use property, the deduction is valued at how much the property’s fair market value decreased because of the damage caused by the disaster or the client’s basis in the property (whichever value is lower). The same formula applies to business-related property that was not entirely destroyed.
However, the calculation does not end there. The client must then account for any actual or anticipated insurance reimbursement (the client may be required to amend the return to account for after-acquired insurance proceeds) or salvage value of the property. After insurance is subtracted, the client must reduce that value by $100 (assuming only one natural disaster caused the damage—the rule is that the client must subtract $100 per event). After that reduction, the client subtracts 10 percent of his or her adjusted gross income from the value to reach the actual dollar figure that can be deducted.
Additionally, it’s important for the client to determine the year in which to take the deduction—which is generally the year the disaster occurred. However, for federally-declared disasters, the client can choose to take the deduction in the preceding tax year by accounting for the loss on that year’s return or filing an amended return.
As this summer has shown, clients do not have to live in a hurricane-prone area to be impacted by natural disasters. Flooding, fire and tornadoes can generate the same—if not greater—levels of destruction, making it important for these clients to understand their options for obtaining a tax benefit to help them rebuild.