Tax Treatment of Disaster Losses Creates Post–September 11 Concern

The ripple effect from the Sept. 11 terrorist attacks on our country is flowing through every aspect of our nation’s existence. Taxes are no exception.

Today, “casualty loss” must include within its definition destruction by terrorism. The old image of casualty loss resulting from fire, flood or other natural disaster is insufficient. Sudden and unexpected harm—the trigger for a casualty loss—can come, we have learned, from terrorist attacks.

The Rules

The casualty loss rule is straightforward. Taxpayers can claim as a casualty loss the lesser of the difference between the fair market value of the property before the casualty and the fair market value immediately after the casualty or the adjusted basis of the property immediately before the casualty. Businesses have no minimum threshold to meet; individual taxpayers, along with estates and trusts, must absorb the first $100 of casualty loss. Individual, estate and trust casualty losses also are reduced by 10 percent of adjusted gross income. Trust and administration expenses reduce the 10 percent floor on the deduction. A casualty deduction is usually taken by the property’s owner, but may be claimed by a lessee required to maintain the property.

Because of the lack of “physical” harm, economic loss, regardless of how crippling, cannot qualify as a casualty loss. Economic losses for business taxpayers, such as lost profits, may qualify as a business loss or may serve to reduce the amount of gain, but only if there is a taxable event, such as a sale, abandonment or complete destruction. Personal economic loss, such as lost value of an investment, may be deductible as a capital loss or as a smaller gain over what would have been realized without the casualty event when the investment is sold. For business owners, the logistics of computing casualty loss can be daunting. Every piece of equipment, every item of inventory, and so forth, for which a casualty loss is claimed, must be valued. The loss of anticipated income, whether caused by a hurricane or a terrorist, does not generate a casualty loss deduction, on the theory that the anticipated income is never taxed.

Timing Considerations

Locations hit by terrorist attacks are presidentially declared disaster areas just as President Bush proclaimed New York City and Arlington, Va. Individual or business taxpayers in these areas must weigh carefully when to deduct their casualty losses. They have the option of taking their deductions either in the years of the disaster or in the year immediately prior to the year in which the loss was sustained. Taxpayers in non-presidentially declared disaster areas must take their deductions in the year they sustained the casualty loss.

Taxpayers seeking immediate relief generally will want to claim their casualty losses in the year prior to the disaster. They will need to file an amended return, a return if one had not been filed, or a refund claim. The election can be revoked within 90 days. However, if an individual anticipates lower adjusted gross income (AGI) in the year of the disaster than the previous year (or discovers such circumstance within 90 days of filing the amended return), tax savings may be greater by deducting the casualty loss in the year of the disaster. As a result, those who do not need the ready refund cash should wait until AGI for the casualty year can be determined before deciding whether to go the amended return route or not.

Businesses not hamstrung by the 10 percent rule have greater flexibility. If the deduction creates a net operating loss, the taxpayer, including individuals, may want to claim it in the year before the disaster and carry over any loss. The portion of a net operating loss that constitutes a casualty loss generally can be carried back three years and carried forward 20 years.

Finally, either an individual or business taxpayer may also choose to accelerate their tax benefits simply by lowering the amount of their estimated tax payments due for the remaining quarters of the current casualty year.

Reimbursement

Insurance may negate a taxpayer’s casualty loss and even create a gain. The amount of loss covered by insurance reduces the total amount of casualty loss. Insurance reimbursement for lost business profits, on the other hand, results in ordinary income without any offsetting allowable casualty loss deduction.

Other types of reimbursement are treated differently. Federal Emergency Management Agency payments do not reduce a taxpayer’s casualty loss. Depending upon their terms, state-sponsored business loans may, like insurance, reduce taxpayer’s casualty loss.

Cleanup and Repair

The costs of cleanup and repair of physical damage are not part of a casualty loss. Repair costs can, however, be used to measure the reduction in the property’s fair market value. Some restrictions exist. Repairs must restore, though not improve, the damaged property. In this respect, substandard repairs can be discounted.

Improvements are the classic trap for disallowing the casualty loss to the extent claimed by the taxpayer. When repairs go beyond restoring property to its condition before the disaster and improve the property, their costs are inadequate evidence of the amount of loss. The cost of repairs also must not be excessive. Repair costs should be based on the actual cost of repairs and not estimates. Estimates are only relevant as part of the case to be made for an appraisal of a property’s loss in value.

Involuntary Conversion

In presidentially declared disaster areas, replacement property is afforded special treatment. Taxpayers can replace property held for productive business use or for investment with dissimilar replacement property if the original property was compulsorily or involuntarily converted. Any gain is unrecognized so long as the replacement property is tangible property held for productive business use.

Gain is also unrecognized on insurance reimbursements for unscheduled personal property in a taxpayer’s principal residence regardless of the ultimate use of the reimbursement. The rule applies to homeowners and renters when their principle places of residence are involuntarily converted.

Disasters displace people from their homes. The cost of temporary accommodation is not part of a casualty loss. However, any insurance reimbursement for temporary accommodation, which is attributable to normal living expenses, may be excluded when calculating casualty loss.