Kicking You While You’re Down: Tax Deduction Limits of “Casualty” Losses
Stan Rose, Managing Director, Tax Practice
There are many types of losses people experience that generate potential tax deductions. Property damage, theft, and inability to collect a debt are just a few examples. The tax treatment of losses varies widely, with the rules providing very different treatment for business, investment and personal losses. The purpose of this article is to provide an overview of the tax treatment applicable to personal losses that are unrelated to business or investment endeavors. For tax purposes, these are referred to as casualty losses, and the tax treatment is rather unique – both in the way such losses are defined and in how the related tax deductions are allowed and limited.
Which losses are deductible?
Non-business, non-investment losses generally result in tax deductions only if they qualify as casualty losses. This occurs if a taxpayer experiences a loss, damage or destruction of property that can be traced to a specific event that meets at least one of three criteria: The event must be (1) sudden, (2) unexpected or (3) unusual.
- Sudden: To meet this definition, the damage or loss must occur swiftly, as opposed to gradually or progressively. For instance, damage resulting from weathering, termites or moths fails this criteria. Damage resulting from storms usually qualifies.
Unexpected: This seems self-explanatory, but an unexpected event must be unanticipated and unintended. Intentionally-set fires or intentionally-caused automobile “accidents” fail this criteria.
Unusual: This also seems somewhat self-explanatory, but to meet this criteria, the event cannot be part of a day-to-day occurrence or otherwise typical of the activity. Glassware that was dropped and broken and carpet damage from an untrained pet are examples that generally will fail this criteria.
Losses that survive the limitations described above face some mathematical hurdles as well.
How is the loss deduction computed?
Casualty and theft losses are computed and reported on IRS Form 4684. Logically, a loss would be equal to what was paid for the damaged, destroyed or stolen property. But of course in the tax world, things can never be that simple.
Your starting point in computing a deductible loss is to determine your basis in the property just prior to the loss event. In most cases, this will be the amount you paid. Then, you must separately compute the decrease in value resulting from the loss. (This step accounts for the fact that the property value may have changed since you acquired it, and your loss may be partial, rather than complete.) Whichever of the two results above yields the smallest number, that amount is reduced by any insurance reimbursements, resulting in a tentative loss amount. From there, it must undergo two additional limitations.
First, your tentative loss described above must be reduced by $100. Then, it must be reduced again by 10% of the adjusted gross income you report for the year of loss. (The combination of these two limitations serves to restrict deductible losses to those that are significant, both in total dollar amount and relative to the victim’s income.) The resulting amount represents a deductible loss. It is reported as an itemized deduction on Form 1040, Schedule A. It is not subject to the overall phase-out of itemized deductions that applies to “high income” taxpayers.
It is possible to incur a casualty gain, rather than a casualty loss. This generally occurs when insurance proceeds exceed a taxpayer’s basis or decrease in value. Any such gain may be taxable, whether received in the year the casualty event occurred, or a following year.
There are plenty of more detailed requirements and several exceptions accompanying the general rules described above. A good source of additional information is IRS Publication 547.
As noted above, casualty and theft losses represent only one category of losses an individual can encounter. They are distinguished from investment losses and business losses, which are subject to different sets of rules. Unfortunately, the ones applicable to casualty and theft losses are so limiting that deductions may only equal a fraction of the true loss.
If you would like to discuss further, please call your BNN tax advisor at 1.800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.