The devastating wildfires throughout East Tennessee have affected us all in some way. We should be proud to live in such a community-focused area that, in spite of tragedy, has already begun to rally together to restore and strengthen our region. Pugh CPAs has received several questions related to the individual and business tax implications of the restorations and improvements to come in the near future. This summary is to make taxpayers aware of the basic federal tax reliefs available for unfortunate events such as the wildfires in East Tennessee.
Businesses and individuals that experience physical damage, destruction or loss of property from a sudden, unexpected or unusual event (the wildfires throughout our region would qualify) may be able to recoup some of their losses through tax savings. In general, the tax law allows individual taxpayers to take casualty losses as an itemized deduction on Schedule A and for businesses to take losses in a similar fashion as the disposition of business property.
Calculating the Loss
The calculation for determining the deductible amount of casualty loss is computed by subtracting any insurance or other reimbursement received (or expected to be received) from the smaller of:
- Decrease in fair market value (FMV) of the property as a result of the casualty, or
- Adjusted tax basis in the property before the casualty
The decrease in FMV is not considered if your property is stolen or completely destroyed.
For individual taxpayers, there are additional limitations to the amount that can be deducted. After calculating the loss, the amount must be reduced by $100 and then reduced by 10% of the taxpayer’s adjusted gross income (AGI). Below are two examples showing the deduction for businesses and individuals:
Example 1 – Business Deduction
A business owner’s building was damaged by a fire. The building originally cost $1,000,000 (excluding land) and has taken $350,000 of depreciation over the life of the building and has a fair market value of 900,000. The insurance company reimbursed the business $600,000 for the damages and the fair market value of the building after the fire dropped to $200,000. The deductible loss is computed as follows:
Example 2 – Personal Deduction
An individual’s mountain cottage was damaged by a fire. The cottage originally cost $144,800 (excluding land). The FMV of the property immediately before the fire was $180,000 and immediately after the fire was $35,000. The insurance company reimbursed the individual $130,000 for the damage. Additionally, the individual’s adjusted gross income (AGI) is $80,000.
Insurance and Other Reimbursements
As detailed above, insurance proceeds distributed for the loss property will reduce the related casualty loss that you’re allowed to deduct. However, as demonstrated in our community this past week, there has been an outpouring of support and donations from individuals, businesses and charitable organizations. The IRS is very specific about how to calculate your casualty loss depending on the source of the reimbursements. We have listed the most common sources of funds below and their treatment:
- Employer’s emergency disaster fund – taxpayers must reduce their loss by the employer-provided funds used to replace or repair loss property
- Cash gifts – cash gifts (including for example, the Dollywood Foundation money pledged by Dolly Parton last week) received by disaster victims do not reduce the casualty loss, and there are no restrictions on how this money can be used
- Insurance payments for living expenses – if the taxpayer’s main home is lost due to the casualty or government authorities do not allow the taxpayer access to the main home due to the casualty (i.e. if you were evacuated), then you are not required to reduce the casualty loss by the payments received for the time period that one of the previously stated conditions are met
- Disaster relief – food, medicine, medical supplies, and other forms of assistance do not reduce your casualty loss, unless they are replacements for lost or destroyed property (exception for Federally-declared disaster areas)
When to Deduct the Loss
A casualty loss is generally deductible in the year the casualty occurred. However, if a casualty loss occurs within a federally declared disaster area, taxpayers can elect to deduct the loss in the tax year that precedes the year in which the disaster occurred by filing an amended tax return. As of the posting of this article, President Obama has not designated our region as a Federally-declared disaster area (See www.fema.gov/disasters for a current list). The Federal Emergency Management Agency (FEMA) has issued a Fire Management Assistance Declaration in their discretion. We will publish additional guidance on these if they become applicable to our area.
For income tax purposes, only losses to property are deductible as casualty losses. You can’t deduct the loss of future earnings if your business is damaged in a fire, nor can you deduct the loss of time you spent cleaning up after the fire. However, your casualty loss could generate a net operating loss that you could use to lower your taxes on returns up to three years prior to the event (five years in specific situations) or twenty years forward.
If the amount received as insurance reimbursement exceeds the adjusted tax basis of the damaged or destroyed property, taxpayers may have a gain as a result of the casualty. However, the fact that a gain exists does not necessarily mean that it will be immediately taxable. Taxpayers who plan to purchase qualified replacement property within two years after the end of the year the casualty occurred (or three years for real property used in a trade or business or held for investment) may be able to defer a portion, if not all, of the casualty gain. Note that the tax basis in the replacement property must be reduced by the amount casualty gain deferred. The replacement property must be similar or related in use to the property that was destroyed. Replacement property acquired from a related party is not eligible for gain deferral.
Taxpayers with business income insurance covering the loss of income due to disasters or other interruptions in income must report and pay taxes on all insurance proceeds received to replace or recover lost income.
This summary only provides a brief overview of the casualty loss rules. The tax rules for this situation are complex and voluminous. Please consult us to discuss the specifics of your situation and the opportunities available to you.