Casualty Losses for Property Damaged by Superstorm Sandy
By Robert S. Barnett, Esq.
Elizabeth Forspan, Esq.
Capell Barnett Matalon & Schoenfeld, LLP
100 Jericho Quadrangle, Suite 233
Jericho, New York 11753
Tel: (516) 931-8100 Fax: (516) 931-8101
E-mail: email@example.com, firstname.lastname@example.org
Many homeowners have unreimbursed losses in the wake of Superstorm Sandy. Maximizing available tax benefits will be extremely important to enable cleanup and recovery efforts. This article reviews the IRS rules regarding casualty loss deductions.
What is a casualty loss?
A loss from a casualty arises as a result of a sudden, unexpected or unusual cause, including those that arise from fire, storm, shipwreck or from theft (IRC Section 165(c)).Storm damage will include loss to shoreline structures from battering by waves and winds or flooding of buildings due to the storm.
May an individual deduct a casualty loss?
Damage to nonbusiness property caused by a hurricane or flood is deductible according to a special set of rules (Treas. Reg. Section 1.165-7(a)(1)). The loss is generally deductible in the year in which it is sustained (see below). An individual may claim an itemized deduction if he/she suffers a casualty loss to personal property, but only with respect to the portion of the loss for which the individual will not be compensated by insurance (as discussed in greater detail below) and only to the extent the losses exceed 10% of the individual’s adjusted gross income (AGI) plus $100 per casualty (Section 165(h)). The casualty loss is deducted on Form 4684 and is reported as an itemized deduction on Schedule A of Form 1040.
Note that under Treas. Reg. Section 1.165-7(a)(3), an automobile (whether used for personal or business purposes) may be the subject of a casualty loss.
May a casualty loss deduction be claimed for damage to insured property?
An individual may claim a deduction for damage to insured property, but only if a timely insurance claim has been filed (Section 165(h)(5)(E)). If a claim is not filed, any portion of the loss that is covered by insurance will not be deductible. (Section 165(h)(5)(E)). Any loss actually sustained during the taxable year and not compensated by insurance or another form of compensation is allowed as a deduction (Treas. Reg. Section 1.165-1(a)). The individual may not deduct the portion of the loss with respect to which there is a reasonable prospect of recovery. Thus, in determining the amount of the deduction, taxpayers must determine whether or not there is a reasonable prospect of recovery, which is discussed in greater detail below.
Amounts received as compensation to replace damaged property will reduce the amount of the deductible loss. Excludable gifts will not reduce the deduction, even if it they are used to repair the damaged property (Rev. Rul. 64-329). In Revenue Ruling 64-329, an individual suffered extensive hurricane damage and used cash gifts given by relatives and neighbors to repair his home. The IRS allowed him to claim the full amount of the casualty loss without taking into consideration the money received as gifts.
How should a taxpayer treat payments from an employer to replace and repair damaged property?
The IRS has issued Information Release 2012-84, which discusses qualified employer payments in the wake of Sandy.
Under Section 139(a), gross income will not include amounts received by an individual as a qualified disaster relief payment. A qualified disaster relief payment includes amounts paid to or for the benefit of an individual to pay for: (1) reasonable and necessary personal, family, living or funeral expenses, not otherwise compensated by insurance) incurred as a result of a qualified disaster or (2) expenses (not compensated by insurance) for the repair or rehabilitation of a personal residence, or repair or replacement of its contents, to the extent the work is needed because of a qualified disaster. (Section 139(b)). A qualified disaster includes a federally declared disaster and a disaster that results from an event that the IRS determines to be catastrophic in nature. (Section 139(c)). The Service has determined that Hurricane Sandy is a catastrophic event under this Code Section. (IR 2012-84) Thus, employer payments for qualified disaster relief will not be includible by the taxpayer.
How to value the loss.
Section 1.165-7 of the Treasury Regulations provides a roadmap for valuing the amount of the loss that is deductible. Under the Regulations, the fair market value (FMV) of the property immediately prior and immediately after the casualty should be ascertained by a competent appraisal. “The appraisal must recognize the effects of any general market decline affecting undamaged as well as damaged property which may occur simultaneously with the casualty, in order that any deduction under this section shall be limited to the actual loss resulting from damage to property.” (Treas. Reg. Section 1.165-7(a)(2)(i)). The Regulations require the loss to result from and reflect property damage from the storm.
Cost of Repairs.
Under the Treasury Regulations, the cost of repairs to damaged property is acceptable as evidence of the value of the loss. The taxpayer must show that: (1) the repairs were necessary to restore the property to the same condition it was in immediately prior to the casualty; (2) the amount spent on the repairs was not excessive; (3) the repairs were not for anything other than the damage; and, (4) the value of the property after the repairs does not exceed the value of the property immediately prior to the casualty. (Treas. Reg. Section 1.165-7(a)(2)(ii)).
How much can an individual deduct for casualty loss to personal property?
As mentioned above, individuals cannot deduct the first $100 of the loss. Additionally, the individual may only deduct casualty losses to the extent the total amount of the individual’s losses during the taxable year is in excess of 10% of his AGI. Moreover, another limitation is the taxpayer’s basis, the computation of which is described in greater detail below.
Example: Arnie’s home suffered a flood as a result of the recent storm. His loss after insurance and other reimbursements was $10,000. Arnie has an AGI of $50,000.
(Note that in the wake of Hurricanes Katrina, Rita and Wilma, Congress acted to eliminate the 10% of AGI limitation described above, as well as the $100 threshold. There is a good chance that Congress will act to extend similar leeway to victims of Sandy. Tax practitioners should stay abreast of upcoming legislation).
How does one Measure the Amount of the Actual Loss?
The amount of the casualty loss is the lesser of:
- The difference between the FMV of the property immediately prior to the casualty and its FMV immediately after, or
- The adjusted basis of the property immediately before the casualty (Tres. Reg. Section 1.165-7(b)).
Example: Maria’s home was destroyed by Superstorm Sandy. The house cost her $30,000. The FMV of the house immediately preceding the storm was $50,000. The FMV immediately after the fire was $20,000. Maria also collected $20,000 from her insurance company. Maria’s AGI is $50,000. Maria’s deduction for the casualty loss is $4,900.00.
*Assumes no reasonable prospect of recovery for the remainder of her economic loss.
Note: In this example, the $30,000 decrease in FMV does not exceed Maria’s basis in the property (cost plus improvements and capital expenditures).
Will the casualty loss affect an individual’s basis in the affected property?
Yes. The basis of damaged property will be decreased by (1) the amount of insurance or other reimbursement received or available to be received or recoverable in the year the casualty loss was sustained, and (2) the amount of loss that is deductible. (Rev. Rul. 71-161). However, it is important to note that amounts spent on restoration of the damaged property will be added back to the basis.
Example (Based on Rev. Rul. 71-161). As a result of the hurricane, Jimmy sustained property damage to his home that is deductible as a casualty loss. The basis in the property immediately prior to the hurricane was $50,000, with a FMV of $50,000. Right after the hurricane, the FMV of the property was $40,000. Jimmy paid $2,000 for debris removal and $8,000 for repairs to the property, both of which restored the property to its original condition prior to the hurricane. Jimmy received $1,400 from insurance reimbursement in the year of the hurricane for the debris removal, but did not receive the additional $600 until the subsequent year. Jimmy’s basis in the property is reduced by the amount of the allowable deduction. His basis must also be reduced by the amount of insurance or other compensation he received or is recoverable in the year of the loss. Thus:
|Jimmy’s adjusted basis before the casualty loss:||$50,000|
|Minus (1) the allowable casualty loss deduction||-$8,600*|
|Minus (2) insurance or other compensation received or recoverable in the year of loss||-$1,400|
|Jimmy’s adjusted basis after the casualty:||$40,000|
|Plus (1) debris removal expenses||+$2,000|
|Plus (2) expenses for repairs||+$8,000|
|Jimmy’s adjusted basis after restoration:||$50,000|
*Assumes no reasonable prospect of recovery in the year of the casualty loss for the $600 received in the next year.
** Taxpayer will have income on receipt of the $600 in Year 2 (year of receipt); he already claimed a deduction in Year 1 that included the costs. (Rev. Rul. 71-161 quotes Treas. Reg. Section 1.1016-6(a): “Adjustments must always be made to eliminate double deductions or their equivalent.”)
During which taxable year may the loss be deducted?
A casualty loss is generally deducted in the year in which the loss is sustained as described below. Superstorm Sandy was declared a federal disaster in much of the New York/New Jersey area and, taxpayers will have the choice of either deducting the loss in 2012, or in the prior tax year. Other than in the case of federally declared disaster areas, the casualty loss for federal income tax purposes is deductable only in the year in which the casualty occurs. (Treas. Reg. Section 1.165-1(d)(1)).
Under the Treasury Regulations, “a loss shall be treated as sustained during the taxable year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year.” (Treas. Reg. Section 1.165-1(d)(1)). The Regulations go on to further state that if a casualty results in the loss, and in the year of the loss there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained – until it can be ascertained with reasonable certainty whether or not the reimbursement will be received. (Treas. Reg. Section 1.165-1(d)(1)(i)).
This presents a dilemma for tax practitioners because no claim for deduction is allowed for that part of the loss for which a reimbursement is expected, until it is known whether the reimbursement will be received. Under the Regulations, whether a reasonable prospect of recovery exists with respect to the loss is a facts and circumstances determination. Both the Internal Revenue Code and the Treasury Regulations are silent as to the delineation of the particular facts and circumstances that will be considered in determining if there is a reasonable prospect of recovery. Case law indicates that facts such as a taxpayer’s decision to litigate the matter should be considered. (Scofield’s Estate v. Comm., 3 AFTR 2d 1054). Settlement of a claim or an abandonment of a claim will also indicate whether or not a reasonable prospect of recovery exists.
It is important to note that if an individual deducts a loss in one year and receives a reimbursement for that same loss in a subsequent year, then the reimbursement should be included in his gross income for the taxable year in which it was received. (Treas. Reg. 1.165-1(d)(1)(iii).
Please note that as described in greater detail below, if one’s casualty loss exceeds her gross income for the year, the amount in excess of gross income may be treated as a net operating loss and carried back to prior tax years and over to other years.
Are there special rules with respect to Federally-declared disaster areas?
Yes. In general, casualty losses are deductable in the year in which the casualty occurs (with available carry-backs and carry-forwards). However, for losses that occur in a Presidentially-declared federal disaster area, the individual may choose whether to deduct his/her losses in the taxable year in which the disaster occurred or claim the deduction for the prior year.
The election is made either by filing an amended return or a refund claim. An election statement must be prepared and attached to the return. The statement must include relevant information about the casualty, including the time, place, and nature of the disaster.
The decision largely depends upon the relevant income for the respective years. An individual who chooses to deduct the loss in the prior taxable year may be entitled to an immediate refund. If an election is made to take the deduction in the prior year, the casualty will be treated as having occurred in the taxable year for which the deduction is claimed (Section 165(i)(2)). (Due to the fact that much of the area affected by Superstorm Sandy was officially declared a federal disaster area, those affected must determine if it is beneficial to file an amended return and claim a refund for the prior year).
How can an individual with a casualty loss protect against the tax statute of limitations (SOL)?
Preserving the tax statute of limitations is a very important issue because in many instances the year of deductibility as well as the amount of the casualty sustained and insurance recovery may not be determinable.
There may be a reasonable prospect of recovery with respect to the entire loss, in which case the tax practitioner may determine that there is no allowable current deduction and as a result may not claim the loss in the year of the casualty. The insurance company may ultimately dispute the amount of damage or may altogether refuse to pay certain amounts. In such a case, a loss will be available when the factors become determinable. Unfortunately the IRS may not agree with the taxpayer’s determinations and calculations. It is incumbent upon the tax practitioner to ensure that the relevant tax years are kept open even though there are several factors that may not become known until many years later.
In order to accomplish the goal of keeping the statute open, the tax practitioner should file a protective claim with the IRS for all years in which he or she reasonably believes there could be an allowable deduction.
Thus, in the situation where the taxpayer was expecting insurance recovery, the tax practitioner should file a protective claim if the full casualty loss was not claimed in one year. If all payments and deductions are not resolved for such year, then a protective claim should also be filed for succeeding tax years. (See discussion on NOL below where a protective claim should be filed with respect to those years).
A protective claim should notify the IRS of all the relevant issues. It is important to note that a protective claim will be valid even if it does not state a particular dollar amount or demand an immediate refund. The protective claim will put the IRS on notice and will prevent the IRS from later claiming that the statute of limitations for the relevant tax year has passed. The claim will be sufficient if it identifies the contingencies affecting the claim, is sufficiently clear and definite to alert the IRS as to the essential nature of the claim and if it identifies a specific year or years for which a claim for refund is sought. In essence, a protective claim is a present claim contingent on a future event and that upon happening of the contingency, the claim will be asserted. (See CCA 201136021). Tax practitioners might consider the following as applicable disclosure:
This 1040X is filed as a protective claim relating to a casualty loss suffered as a result of Hurricane Sandy on October 30, 2012. The taxpayer has not reported a casualty loss for 2012 due to the expectation of a reasonable prospect of insurance recovery. This protective claim is necessary should the year of deductibility be determined to be 2012. Losses are expected to be approximately $50,000.
Is there an opportunity to carry back a net operating loss (NOL)?
Yes. There may exist an opportunity for an additional refund. Individuals have the opportunity to claim an NOL for losses that exceed the amount that can be utilized in the year the loss was sustained and reported. For those who suffered severe damage, the casualty loss may exceed their income and therefore they will not be able to maximize their casualty loss deduction for the year in which the loss occurred. The IRS allows the individual to treat the loss as an NOL and carry it back to prior years. If income was insufficient in the prior years, a carryforward is available.
Of course, there are requirements regarding when the NOL claim can be filed. Our recommendation is that tax practitioners should file the NOL claim immediately on a Form 1045. This will allow affected taxpayers to receive a prompt refund, at the same time preserving the SOL. The Form 1045 is used by an individual to apply for a quick refund resulting from, among other things, a carryback of an NOL. The IRS will process the application within 90 days from the later of (1) the date the taxpayer files the complete application, or (2) the last day of the month that includes the due date (including extensions) for filing that tax year’s income tax return. (As described below, the claim may also be filed on a Form 1040X, however, a Form 1045 will generally elicit a more timely response from the IRS).
When filing a Form 1045, the individual should attach pages 1 and 2 of the taxpayer’s Form 1040 for the year of the loss, as well as any other applicable schedules as required by the filing instructions. The taxpayer must attach a computation of the NOL using Schedule A (Form 1045) and a computation of any NOL carryover using Schedule B (Form 1045). When filing a Form 1040X, amended return, for a net operating loss, the taxpayer should enter “carryback claim” at the top of page 1 of the Form 1040X.
Under Treas. Reg. Section 1.172-1(c), the taxpayer who is claiming a net operating loss deduction for any taxable year, must file with his return for such year, a concise statement setting forth the amount of the net operating loss deduction claimed and all material and pertinent facts relative thereto, including a detailed schedule showing the computation of the net operating loss deduction.
In general, a taxpayer may carry back an NOL for two years and then forward for up to 20 years. However, the there is a special rule for casualty and theft losses. With respect to these losses, the carryback period is three years. The NOL must first be carried back to the earlier of the three years prior to the NOL year and then to the next year and then to the year immediately preceding the NOL year. The NOL may only be carried forward to the extent it is not utilized in the prior years. Congress had enacted a special five year carryback for those who suffered damage as a result of Hurricane Katrina. Tax practitioners should keep on alert for any new legislation that may extend the carryback for Sandy’s victims.
As mentioned above, an individual may claim an NOL on either a Form 1045 (Application for Tentative Refund) or a Form 1040X (Amended U.S. Individual Income Tax Return). The Form 1045 should be filed no later than one year after the NOL year. If the claim is filed more than one year after the close of the NOL year, the it must be filed on a Form 1040X within the relevant SOL for the loss year. A separate 1040X must be used for each carryback year to which the NOL will be applied.
Special conversion rules with respect to property damaged in a federal disaster.
Generally, under Section 1033, if property is destroyed as a result of a storm (in whole or in part), no gain will be recognized if the destroyed property is converted into similar property within two years. (Section 1033(a)(1)). However, if the property is converted into money or dissimilar property, the gain will generally be recognized. Similarity is measured by use or service of the destroyed property.
Section 1033(h) includes special rules for property damaged in a federally declared disaster:
First: There is a four year replacement period for the destroyed property (four years after the close of the tax year during which the gain is first realized as a result of the conversion).
Second: Taxpayers need not be concerned with the specific classification of personal items. For example, when property, such as a sofa, is destroyed in a non-federally declared disaster, the taxpayer generally must replace the sofa with another sofa. Under the special rule, the funds are not specifically required to be used to replace the exact item of damaged property; rather, the proceeds for the damaged property are treated as a “common pool of funds” and the taxpayer will not be required to prove whether the insurance proceeds received for a specific item were reinvested in similar or related property.
Third: Section 1033(h) provides a rule for property that is not specifically scheduled in a taxpayer’s insurance policy. Under this Section, no gain is recognized by the taxpayer on receipt of any insurance proceeds for destroyed personal property which was part of the contents of taxpayer’s residence and was not specifically listed on a schedule in the insurance policy. (Section 1033(h)(1)(A)(i). This rule provides additional help to taxpayers affected by Sandy.
Please note that for purposes of these special rules, a principal residence has the same meaning as under Section 121; however, there is no requirement of ownership (i.e. renters who fall under this special rule will be protected).
Section 1033(h) also provides for trade or business and investment property located in a disaster area which is destroyed. Any tangible property used for a productive use in a trade or business is treated as similar/related property and would satisfy Section 1033 for conversion purposes.
The IRS requires taxpayers to disclose when they acquire the replacement property. (The statute of limitation for assessment of gain upon the conversion of the property is 3 years from the date the IRS is notified of the replacement of the converted property or of an intention not to replace).
Retirement Plan Loans.
IR News Release 2012-93 clarifies that qualified employer retirement plans
can make loans and hardship distributions to those affected by Hurricane Sandy and their family members. A person outside the disaster area is able to assist a son, daughter, parent, grandparent or other dependent who lives or works in the disaster area. Hardship distributions are permitted for food and shelter. Qualifying distributions must occur between October 25, 2012 and February 1, 2013. Plans must be timely amended to allow these distributions or loans. (IR News Release 2012-93).
Computation of Business Casualty Loss.
A casualty loss incurred in a trade or business or in a transaction entered into for profit is computed and determined as described above by reference to the fair market value before and after the casualty. However, in a business context, each identifiable property is viewed separately. The Treasury Regulations give an example of a building with ornamental trees, and requires that the computations and basis limitations be computed separately for the trees and the building. This would also require separate computations for automobiles destroyed.
In comparison, if the property were a personal residence not used in business or for profit, the calculation of the trees and building are made in the aggregate, as they are considered integral parts of the property. The automobile would still be considered separately.
Property Converted from Personal to Business Use
If damaged property was not originally used in a trade or businesses or for income-producing activities but was converted from personal use the loss may be limited. If the fair market value of property was less than the adjusted basis of the property at the time of conversion to business or income production, that lower market value becomes the starting point for the computation of available basis. This may limit the amount of casualty loss available. (See Treas. Reg. 1.165-7(a)(5)).
Home Office Considerations.
Casualty loss deductions must be allocated between business and personal use of the dwelling. The business expense consideration described below will apply to the portion of the residence used as an office. Additionally, the 10% of AGI limitation as well as the $100 limitation discussed above only apply to the personal use portion of the property. If the taxpayer files a Schedule C, Forms 4684 and 8829 are used to claim the deduction.
Expense Considerations Under IRC §162 – Expenses resulting from a casualty to a trade or business may be deducted either as a casualty loss or as an ordinary and necessary business expense.
A business has a choice of deducting the loss as a casualty loss or claiming the expenditure as a business expense under Section 162. This section describes some of the factors to be considered.
A casualty loss to a trade or business may be allowable either as a casualty loss or as an ordinary and necessary business expense under Section 162. However, businesses are barred from “double-dipping” and claiming the same deduction twice. In R.R. Hensler Inc. v. Commissioner, a construction company repaired and replaced equipment damaged in a heavy rain storm. The company was permitted to deduct the costs of repair and replacement in the year paid as a business expense. In this case, the Tax Court ruled that the expenditure was “ordinary and necessary” even though the taxpayer had insurance. As a business expense, the taxpayer did not have to wait until a later tax year when its casualty loss insurance claim was settled. The court noted that, “There is no suggestion in the statutory language or legislative history of Section 162 or its predecessors that a business expense may not be deducted under that provision because it is specifically allowable as a deduction under some other section of the Code.” (R.R. Hensler Inc. v. Commissioner, 73 TC 168). The later insurance recovery would be reflected as income.
The court also mentioned the issue of whether recovering, repairing and replacing the equipment destroyed in the heavy rain was an ordinary and necessary business expense or whether such expense needed to be capitalized. The court found the expenses were allowable business expenses. The court did not need to specifically examine whether the expenditures were capital in nature; it was stipulated that the expenditures did not constitute permanent benefits or improvements to the machinery and equipment and that the repairs did not prolong the life of the equipment, or increase its value or make it adaptable to a different use. When deciding whether to deduct a loss as a business loss under Section 162, it is imperative to determine whether the expenditures are capital in nature.
Chief Counsel Advice 199903030 discusses whether expenses relating to the restoration of business property damaged by severe flooding in the Red River Valley in April of 1997 should be treated as (i) a casualty loss, (ii) repairs deductible as an ordinary and necessary business expense under Section 162, or (iii) a capital expenditure under Section 263. As described above, Section 165(a) allows for a casualty loss deduction; however, no casualty loss is permitted where (i) there is a reasonable prospect of recovery or (ii) basis was insufficient.
The aforementioned Chief Counsel Advice is consistent with R.R. Hensler in discussing the factors to be considered. Under Section 263, no deduction is allowed for “Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.” (Section 263(a)(1)). Capital expenditures include amounts paid or incurred which add to the value or substantially prolong the useful life of the property. Facts and circumstances determine whether capitalization is required. “If the expenditure returns the taxpayer’s property to the state it was in before the situation prompting the expenditure arose, and does not make the relevant property more valuable, more useful, or longer-lived, then it is usually deemed a deductible repair.” (CCA 199903030). However, if the expenditure “materially enhances the value, use, life expectancy, strength or capacity of the property as compared with its status prior to the condition necessitating the expenditure, then this expenditure is capital in nature.” (CCA 199903030). If it is determined that the expenditures are not capital in nature but would rather fall under Section 162, the taxpayer has a choice of deducting the loss according to the casualty loss requirements or as an ordinary and necessary business expense.
In 2006 and 2008, the IRS issued two sets of Proposed Regulations, which would have required capitalization for repair costs, instead of allowing taxpayers to claim a Section 162 deduction. The theory was that a casualty was an extraordinary event. Under those Proposed Regulations, capitalization was required under the basis rules of Section 165 and the repair costs would have been similarly treated. However, in recognition of concerns expressed in the comments to the proposed rules criticizing this harsh treatment, the IRS softened its stance. The Temporary Regulations allow taxpayers “to forgo claiming a Section 165 loss in order to qualify for a Section 162 deduction.” (Treasury Decision 9564, 12/23/2011, IRC Sec(s). 162, Explanation of Provisions). Taxpayers must carefully review the Temporary Regulations before electing Section 162 treatment in order to ascertain whether the new regulations would allow a deduction for the repairs. The Temporary Regulations do not allow taxpayers to claim a casualty loss deduction and a Section 162 deduction. A detailed discussion of the Temporary Regulations is beyond the scope of this article.
It is also interesting to note that filing an insurance claim may not be required in claiming a Section 162 deduction for the cost of repairs. In Wexler Towing Co. v. US, the corporate taxpayer, a barge operator, did not file an insurance claim out of fear that the insurance policy would be cancelled. The court allowed a deduction as a business expense for the cost of repairing the property. (Wexler Towing Co. v. US , 48 AFTR 2d 81-5274).
Loss to Inventory.
In general, the Section 165 rules on casualty losses do not apply to casualty losses to taxpayers’ inventories; rather, the Treasury Regulations refer to the general provisions relating to inventories, under Section 471 and the associated regulations. (Treas. Reg. Section 1.165-7(a)(4). However, the taxpayer may instead choose to claim the casualty loss separately. Care must be taken not to duplicate deductions and to properly reflect any insurance recovery. Casualty losses to inventory may be automatically reflected in the cost of goods sold by properly reporting opening and closing inventories. If included in the cost of goods sold, the losses are not separately deducted as a casualty loss. This is necessary to avoid duplication of the loss. (IRS Publication 538).
An example will help illustrate an important difference between claiming a deduction as a casualty loss or as part of the cost of goods sold. If a taxpayer has a casualty loss to inventory which is reflect in a lower ending inventory, the cost of goods sold will include the lost inventory value. One potential consideration is that the reasonable prospect of recovery of a later insurance recovery will not bar the larger cost of goods sold deduction (but will reduce the casualty loss deduction). Claiming the larger cost of goods sold deduction will help taxpayers receive a quicker tax refund. However, the later insurance recovery will be reflected as taxable income.
Many businesses affected by recent hurricane inventory loss are experiencing reduced business, and profits are expected to be lower. Therefore, the tax paid on the insurance recovery may be more than offset by the business deduction of the cost of goods sold in the earlier year. If the taxpayer elected to claim the deduction as a casualty loss, the reasonable prospect of recovery rule could have barred some or all of the claim.
In light of the above, it is important for all those who suffered losses during the recent devastating storm to begin the process of determining the value of the losses and discuss the potential for tax savings with their tax advisors. Our area was hit especially hard and many counties were declared a federal disaster area, opening up the potential to claim an immediate refund. Pending legislation may affect some of the factors presented in this article.
- IRS Disaster Resource Guide for Individuals and Businesses: http://www.irs.gov/pub/irs-pdf/p2194.pdf
- IRS Disaster Assistance Hotline at 1?866?562?5227
- IRS Tax Relief in Disaster Situations: http://www.irs.gov/uac/Tax-Relief-in-Disaster-Situations
- IRS Disaster Relief Resource Center for Tax Professionals: http://www.irs.gov/Tax-Professionals/Disaster-Relief-Resource-Center-for-Tax-Professionals
- Federal Emergency Management Agency (FEMA)
- Web site: www.fema.gov
- Telephone: 1?800?621?3362
- The Disaster Assistance Portal: http://www.disasterassistance.gov/
- American Red Cross Disaster Services: http://www.redcross.org/prepare/disaster
- Hurricane Sandy Helpline for New York State Residents: 1-888-769-7243
As more information becomes available, please visit our website at www.cbmslaw.com where we will be updating this article.
Robert Barnett, CPA., J.D., M.S. (Taxation) is a partner at Capell Barnett Matalon and Schoenfeld, LLP, attorneys at law in Jericho, New York. Robert’s practice areas include business and tax planning, estate planning, tax dispute resolution and Tax Court representation. Robert can be reached at email@example.com.
Elizabeth Forspan, Esq. is an associate at Capell Barnett Matalon and Schoenfeld, LLP, attorneys at law in Jericho, New York. Elizabeth’s practice areas include asset preservation planning, estate planning, tax planning and elder care planning. Prior to joining Capell Barnett Matalon & Schoenfeld, Elizabeth was a Tax Manager at Ernst & Young LLP. Elizabeth can be reached at firstname.lastname@example.org.
Robert and Elizabeth would like to thank the following people for their contributions to this article: Sidney Kess, CPA, J.D., LL.M; Gerard H. Schreiber, Jr., CPA; Perry Shulman, CPA.