Tax Breaks for Disasters

The hurricane season is upon us and many taxpayers around the country have already experienced devastating property losses from tornadoes, floods, wildfires, and other natural disasters this year. The toll from these events is substantial, both personally and financially. However, there is a little bright spot for victims of these disasters: some of the economic loss can be recouped through tax write-offs.

Figuring deductible casualty losses

If your property is damaged or destroyed in a casualty event, such as a fire, storm or flood, hopefully your insurance will cover all or most of your loss. However, if your insurance falls short, you may claim a tax loss for the damage. There is no dollar limit on how much you can deduct, but you must itemize deductions (in lieu of the standard deduction) to write-off casualty losses.

What's your loss? The tax rules are cold and strict; your loss is limited to the decrease in the value of the property from the casualty or its adjusted basis (usually your cost), whichever amount is smaller. If property is damaged or destroyed, follow this rule of thumb:

• For property that had appreciated from the time you acquired it to just prior to the event, your loss is based on adjusted basis (usually your cost). This rule generally applies to a home.
• For property that had declined in value from the time you acquired it to just prior to the event, your loss is based on fair market value. This rule generally applies to a home's contents.

Note: No deduction is allowed for the sentimental value of items, such as family albums and video recordings.

Limits on your deduction. Even if you have a loss, this doesn't guarantee that it will be deductible. There are two tax law limits on personal casualty losses:

• $100: You must reduce each casualty loss by this amount. It applies per casualty, not per item in the casualty event. If you have the misfortune to suffer two casualties in the same year, say a fire and a car accident, then you have two $100 subtractions.
• 10% of adjusted gross income (AGI): You must reduce your deductible loss by 10% of your AGI. This factor will substantially reduce your deduction and may prevent you from claiming any write-off.

Example: A hurricane damages your home, and your uninsured losses, after reducing them by $100, total $7,600. If your adjusted gross income is $76,000 or more, you cannot take any casualty loss deduction. If your AGI is, say, $50,000, your deduction is limited to $2,600 ($7,600 - $5,000).

When to deduct losses

Usually, you take the deduction in the year in which the casualty occurs. However, if the casualty is a disaster event, where your local area is designated by the president as qualifying for federal disaster relief, you can choose instead to deduct the loss in the prior year (check with the Federal Emergency Management Agency to see if your area has such designation). This can create a tax refund for the prior year, giving you immediate cash to use for rebuilding.

Whether it's a good idea to claim the disaster loss in the prior year depends on your personal tax situation. You'll get the most tax mileage for the deduction in the year in which your adjusted gross income is lower (because of the 10% of AGI threshold explained earlier).

Disaster relief payments

If you are the victim of a disaster, you may receive assistance from the government or nonprofit organizations. These payments to you are tax free, regardless of amount. The following are examples of tax-free disaster relief payments made because of a federally declared disaster:

• Personal, family, living, or funeral expenses.
• Expenses for the repair or rehabilitation of a personal residence, whether you own or rent the home.
• Expenses for the repair or replacement of the contents of a home.

Gain from an involuntary conversion

Having property damage because of a casualty event doesn't mean you have a tax loss. You may even have a tax gain. This results when the insurance proceeds and other recoveries you receive are greater than the adjusted basis of the property. The tax law calls this an involuntary conversion.

Fortunately, if you have an involuntary conversion that gives you a tax gain, you don't necessarily have to pay tax on this gain now. You can postpone the tax by reinvesting the proceeds into replacement property within a set time limit (generally 4 years to replace a home and its contents).

Instead of postponing gain by buying a replacement home, you can exclude gain under the home sale exclusion rules. Assuming you owned and used the home as your principal residence for at least two years prior to the casualty event and the home is considered "destroyed," then gain can be excluded up to $250,000 ($500,000 on a joint return).

Destruction need not be total, but it must be so substantial that it's viewed as a destruction. The IRS says that only a full destruction (not a partial one) qualifies for the home sale exclusion. A full destruction means that the home is damaged to such an extent that the remaining structure can't be used to advantage in restoring the home to its precasualty condition. Another measure of destruction is having the cost of repairs substantially exceed the fair market value of the home prior to the casualty.

If the gain from the involuntary conversion exceeds the home sale exclusion, you can postpone tax on the excess gain by obtaining a replacement home within the 4-year time limit explained above.