8716 / Can a casualty loss be spread over more than one tax year? What is the reasonable prospect of recovery doctrine?

Editor’s Note: Under the 2017 tax reform legislation, individuals are no longer entitled to deduct casualty and theft loss expenses as itemized deductions for 2018-2025 (when those losses are not related to property used in a trade or business). An exception exists for losses that occur in federally declared disaster areas.¹

Generally, a taxpayer is required to claim a casualty loss deduction for the tax year in which the loss was sustained. A taxpayer is considered to have sustained a casualty loss in the year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in the year.²

The fact that a taxpayer is unable to determine the extent of the damage caused or the cost of repairing the damage is insufficient to allow the taxpayer to carry a casualty loss deduction into a succeeding tax year. The Tax Court has determined that an expert appraisal is sufficient to determine the level of damage sustained at the time the casualty loss occurred even if the extent of the damage was not immediately apparent.³

Despite this, the reasonable prospect of recovery doctrine will actually prohibit a taxpayer from claiming a casualty loss in the year the casualty occurs if the taxpayer has a claim for reimbursement with respect to which the taxpayer may reasonably be expected to recover all or a portion of the casualty loss.⁴ The portion of the casualty loss to which the potential for reimbursement relates will be disallowed until it can be ascertained “with reasonable certainty” whether or not the reimbursement will be received.

Example: Brent’s cottage, which had an adjusted basis of $100,000, is completely destroyed by a fire in 2016. His only claim for reimbursement was an insurance claim for $80,000, which he settled in 2017. Brent sustained a loss of $20,000 for 2017. If the cottage was destroyed due to the negligence of a third party, and there is a reasonable prospect that the third party can be held liable for the entire amount of the damage, Brent cannot take a loss deduction until it is determined whether or not he can recover damages from that third party.⁵

Whether a “reasonable prospect of recovery” exists is a question of fact that is determined based on an examination of all of the facts and circumstances of the particular loss being claimed.⁶

If a taxpayer takes a casualty loss deduction for a loss sustained in one year, but receives reimbursement for that loss in a subsequent tax year, the taxpayer is not required to file an amended return for the year in which the deduction was erroneously claimed. Instead, the taxpayer must include the reimbursed amount in gross income for the year it is received.⁷

A special rule applies in the case of casualty losses sustained in a federally declared disaster area. If the taxpayer’s casualty loss was sustained in a disaster area, the taxpayer may elect to take the casualty loss deduction in the year immediately preceding the year in which the loss was sustained.⁸ See Q 8719 for a detailed discussion of the treatment of casualty losses that occur in a disaster area.

The reasonable prospect of recovery doctrine also applies in the case of theft losses (see Q 8712).