Deductions for Casualty and Theft Losses
Casualty and theft losses are generally deductible and reported on Form 4684, Casualties and Thefts, but the amount that can be deducted and the deductibility of incidental expenses, such as appraisals, depends on whether the property is personal, income-producing, or business.
- Personal property: The net loss of personal property can only be deducted if the loss was the result of a federally declared natural disaster. Most expenses that are incidental to a loss, such as documentation expenses or legal expenses, are not deductible.
- The deductibility of personal-use property loss is limited to the following:
- Deduction for Loss of Personal Property from a Federally Declared Natural Disaster = Loss Amount – $500
- Income-producing property: Income-producing properties, such as securities, are also fully deductible and are claimed on Form 4684 and incidental expenses can be deducted on Schedule A under Other Miscellaneous Deductions, not subject to the 2% AGI floor.
- Business property: The full amount of the unreimbursed loss and all incidental expenses can be deducted. The loss for the property is claimed on Form 4684 and on Form 4797, Sales of Business Property, and incidental expenses can be deducted on Schedule C, Profit or Loss from Business, which also saves on employment taxes.
Any deduction is reduced by reimbursement for the loss, such as from insurance.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, casualty losses will only be deductible if the losses were from a natural disaster declared by the President. This provision starts in 2018 and expires at the end of 2025.
The Taxpayer Certainty and Disaster Relief Tax Act of 2019 changed the law for personal casualty losses related to disasters. This new law increases the $100 floor to $500, but waives the 10% AGI limitation and allows the net disaster loss to be added to the standard deduction for taxpayers who do not itemize. A net disaster loss is the qualified disaster-related personal casualty losses exceeding personal casualty gains.
Example: You have a personal casualty loss of $10,000 due to a qualified disaster. Your itemized deductions not including the casualty loss total only $5,000, so you would ordinarily claim the standard deduction, since it offers more tax savings. However, under the new tax law, you can claim the standard deduction plus the $9500 of your personal casualty loss that is deductible, which is $10,000 minus the $500 floor.
Example: Deducting Losses for Personal-Use Property
Your car was damaged by a qualified natural disaster.
|Insurance Reimbursement for Car||$2,000|
|Calculation of Deduction|
|Subtract Insurance Reimbursement for Car||($2,000)|
|Subtract the $500 Floor||($500)|
The deduction is tentative because, as an itemized deduction, only part of it reduces taxes, depending on the amount of other itemized deductions. If you claim the standard deduction, as most taxpayers do, then none of it is deductible.
Losses due to negligence or to willful acts are not deductible, since these are not the result of casualties. Taxes on any gains realized from the loss can be deferred by replacing or repairing the property.
Sudden Event Test
Except for the loss of business property, casualty losses are subject to the sudden event test, meaning that the loss must have been the result of a sudden and unexpected event. The slow deterioration of property is not generally deductible, since most property deteriorates over time and can be prevented or ameliorated by appropriate actions. Except for rare exceptions, the devaluation of property because of external events is not deductible. The property must be actually damaged to claim a deduction. For instance, some people tried to claim losses on homes that they owned that were located near the O.J. Simpson house. They argued that their homes permanently lost value because of the trial publicity associated with the prosecution of O.J. Simpson for 2 murders. But since their homes were not actually damaged, the Tax Court denied their claim.
Generally, losses from foreseeable events and preventable accidents are not deductible since they do not satisfy the sudden event test. So, for instance, losses from termites are generally not deductible, since termite damage typically occurs over several years and is something that property owners should be aware of and should take the appropriate action to mitigate the damage.
There is a special exception, provided by Revenue Procedure 2010-36, for damage because of Chinese corrosive drywall. The cost of repairs is deductible in the year that they are paid rather than when the damage occurred. More information can be found at the Drywall Information Center.
Applicable Tax Year for Claiming Losses
Losses are deductible for the tax year in which they are incurred and paid. However, if the losses only became evident in later years, then they may be deductible in the year that the losses are discovered. If the losses occur because of a federally declared disaster, then the losses can be claimed for the previous year.
If you reasonably expect partial or full reimbursement for losses, then the expected reimbursements should be subtracted from your loss amount, even if the reimbursement, such as from insurance, occurs in a later tax year. If you deducted losses on which reimbursement was not expected, but then later received reimbursements for the loss, then you must include the amount that was deducted as a loss to the extent of the reimbursement as income for the tax year in which it was received.
If the reimbursement exceeds your adjusted basis in the property, then that gain is includable as taxable income. However, the recognition of the income can be delayed if the reimbursement is used to repair or replace the property subject to the loss.
Natural Disaster Losses
Deductions for natural disasters can be claimed when the disaster occurred or for the previous year. If you elect to deduct the loss in the previous year, then the IRS allows a 90 day period to revoke the election, after which it becomes irrevocable. If the tax return has already been filed for the prior year, then you can use Form 1040X to file an amended return. Any grants or loans that provide disaster relief are excludable from income, but the reimbursed expenses cannot be deducted. If the IRS allows an extension to file tax returns and to pay taxes because of a disaster, then the IRS will abate the interest on the taxes for that period.
If homeowners are forced to relocate because the homes have become unsafe after a disaster, then the loss may be deductible even if it does not meet the sudden event test. However, this loss treatment is only allowed if the following conditions are satisfied:
- the home is considered unsafe because of the disaster;
- the President has declared the area to be a federal disaster area;
- within 120 days of the President's order, either the state or the local government issues a requirement that you demolish or relocate the residence.
Any disaster grants for losses of business property are includable in the income of the business to the extent that it exceeds the adjusted basis of the affected property. However, the recognition of gain can be deferred under the involuntary conversion rules by investing the payments in qualified replacement property within 2 years.
If a principal residence is destroyed, then any gains from the payment of insurance for the destroyed property can be excluded under the home sale exclusion, which is $500,000 for a married couple filing jointly and $250,000 for everyone else. However, the property must be completely destroyed — partial destruction will not qualify for the home sale exclusion unless the repair cost of a partially destroyed residence exceeds the pre-disaster value of the home. If you do not qualify for the home sale exclusion or if the gain exceeds the exclusion, then any non-excludable gain can be deferred if a replacement residence is bought within 4 years.
Insurance payments for personal property in a principal residence, whether rented or owned, is not includable in gross income if the personal property is unscheduled property, meaning that it is not listed on a separate schedule or rider to an insurance policy. Insurance payments for the home itself and for scheduled property are treated as a single item of property. Any gain on the insurance payments can be deferred by buying replacement property within 4 years after the 1st tax year in which at least some of the gains were realized. If total insurance payments exceed the cost of the replacement property, then the gain is recognized on the unused reimbursement. The insurance payments reduce the basis of the property by the amount of payments. If a land of a destroyed principal residence or 2nd home is sold so that you can relocate, then the destruction and the sale of the underlying land are treated as a single involuntary conversion. All of any gain can be deferred if a new principal residence is purchased within the 4-year replacement period for a price that exceeds the combined insurance payments and sales proceeds. The single conversion rule also applies to a 2nd residence, such as a vacation home, that qualifies for a mortgage interest deduction, but the replacement period is only 2 years, unless the 4-year replacement period is applicable.
Losses can only be deducted by the property owner. A parent may not deduct the damage to a vehicle registered in a child's name, even if the parent paid for the car. Losses on jointly owned property must be divided among the owners. If a married couple files jointly, then losses by either spouse can be deducted, but if they file separately, then losses can only be deducted by the spouse owning the property.
Investment Theft Losses Are Fully Deductible
Investment losses due to fraud or theft, such as from a Ponzi scheme, are fully deductible. The deduction is not subject to the $500 floor. Revenue Ruling 2009-9 was enacted as a response to the massive losses suffered by investors from Ponzi schemes, such as the Bernie Madoff Ponzi scheme. Investment theft losses can be claimed for the amount invested plus any phantom income that was reported as income in previous tax years minus any expected recoveries. These losses are deductible in the year that the fraud is discovered. If the losses result in a net operating loss, then the NOL can be carried back or forward, as allowed by law.
Revenue Procedure 2009-20 adds a safe harbor for claiming investment theft losses. If the investor does not pursue a third-party recovery, then a deduction equal to 95% of the loss can be claimed. If you decide to pursue a third-party recovery, then 75% of the loss can be deducted. Any actual recovery or potential reimbursement by insurance or from the Securities Investor Protection Corporation (SIPC) must be subtracted. Any amount recovered or reimbursed above the amount deducted must be claimed as income in the year when payments are received.
Write "Revenue Procedure 2009-20" at the top of Form 4684, Casualties and Thefts, in the year that the loss was discovered, then complete, then sign Appendix A of Revenue Procedure 2009-20 and attach it to your tax return.
Substantiating a Casualty Loss
You must not only prove that a casualty occurred and the amount of any loss but also that it was not reimbursed by insurance. Substantiating that a casualty actually occurred is not difficult with well-known casualties, like floods, but proof must be supplied to how it affected your property, such as before and after photographs of the area, newspaper stories about the property, insurance claims, or police, fire, or other municipal reports about the property.
The cost of repairing the property can be substantiated by canceled checks, bills, and receipts. Only the cost to restore the property is deductible — not any improvements.
Since the deduction is limited to your adjusted basis of the property, you must show evidence of the adjusted basis, such as construction contracts or other documents that show original cost. The cost of improvements made before the loss can be proven by canceled checks, credit card receipts or other proofs of payment. The adjusted basis for inherited property can be found in the records of the donor or the personal representative of the estate.
A good way to save records and other documentation is to scan them electronically and use one of the many online services that allow people to save documents online to a remote server. Most of these services are free for at least 5 GB of storage, which should be adequate for most people.
Appraisals for expensive items must be provided to substantiate the before and after value of the property and must be in writing, such as an affidavit, disposition, estimate, or other type of appraisal report. Damage to motor vehicles can be assessed by local garages or auto body shops. There are several so-called blue books that allow you to ascertain the value of a motor vehicle and some are provided on the Internet free of charge, such as:
Damage to a motor vehicle unreimbursed by insurance is generally deductible unless it was for willful misconduct, such as for drunken driving or speeding. However legal costs for litigation are not deductible. A business can deduct unreimbursed damage costs for a vehicle and the expenses of litigation if the car was used within the business. However, commuting or driving from one business to another business is considered personal driving, and is, thus, subject to the personal driving rules.
The actual cost of repairs can be treated as evidence for determining the amount of the deduction, as long as the amount is not excessive and the repairs only restored the property to its previous condition. Repair estimates are not sufficient unless they are used to corroborate appraisals of value before and after the casualty.
However, if the repairs are less than the decline in the fair market value (FMV) of the property, then you can claim the FMV difference rather than the cost of the repairs, if the decline in FMV was due to the casualty. Incidental costs to the accident, such as towing costs, are not deductible for personal-use vehicles.
Personal injury expenses are not deductible as a casualty loss. If a motor vehicle is used both for personal purposes and for business, then the losses are treated as if it they were on 2 separate pieces of property subject to the personal use rules and the business rules. The business portion can be fully deducted, but the personal portion is subject to the subtraction of $100 and the 10% AGI floor that applies to personal casualty losses.
Theft losses are generally deductible, but you may have to provide evidence that the property was actually stolen rather than just misplaced or lost. The theft of money that would've been income but was not reported as income is not deductible.
If stolen property is later recovered, then you may have to include the deducted amount because of the loss as income in the year of the recovery. However, you may still be able to claim a loss if the fair market value of the property was less than when it was stolen.
As with personal casualty losses, deduction for theft of personal property as a casualty loss is an itemized deduction, so if you do not itemize, then the loss is not deductible.
Calculating the Casualty Loss Deduction
Casualty and theft losses are claimed on Form 4684, Casualties and Thefts. These are the steps for calculating a deductible loss on Form 4684:
- Subtract the FMV of the property after the casualty from the fair market value before the casualty. Business or income-producing property is not subject to this rule.
- Determine the adjusted basis of the property:
Adjusted Basis = Improvement Costs – Previous Casualty Loss Deductions – Depreciation – Salvage Value
- The deductible loss is limited by the lower of the reduction in FMV of the property or the adjusted basis. This value is further reduced by any compensation for the loss, such as insurance proceeds.
Personal-use property must be further reduced by $100 for each loss event. However, if more than 1 item has been destroyed by a single event, then only $100 must be subtracted from the total loss. For instance, if a hurricane destroyed many items, then only the total loss must be reduced by the $100 – not each individual item. If property had both a personal use and business use, then only the personal-use apportionment is subject to the $100 reduction — the business portion is fully deductible. The $100 floor also applies to each individual owner of jointly owned property. However, this rule does not apply to married couples filing jointly.
If there are any gains from a casualty loss, such as from insurance proceeds, for the year, then the gains must be offset by any losses before the applicable tax rules are applied. Inventory losses are not computed on Form 4684, but are accounted for as goods sold at the greater of the FMV or zero, if it is a complete loss.
The basis of damaged property must be adjusted downward by the casualty loss deduction plus any compensation received for the loss.
Example: Deducting Losses for Property Used for Business and Personal
You suffer damage to your home from a flood, that was partly used for business. How much of the casualty can you deduct? Any applicable amounts are multiplied by the business use percentage and personal use percentage when calculating the amount of the deduction.
|Total Cost of Loss||$300,000|
|Fair Market Value (FMV) before Flood||$285,000|
|FMV after Flood||$240,000|
|Total Insurance Reimbursement||$40,000|
|Adjusted Gross Income (AGI)||$80,000|
|Calculation of Deduction||Business Use||Personal Use|
|FMV before Flood||$114,000||$171,000|
|FMV after Flood||$96,000||$144,000|
|Decrease in FMV||$18,000||$27,000|
|Loss (smaller of Adjusted Basis or FMV decrease)||$18,000||$27,000|
|Subtract Insurance Reimbursements||$16,000||$24,000|
|Loss after Reimbursement||$2,000||$3,000|
|Subtract $100 on Personal-Use Property||$0||$100|
|Loss after $100 Rule||$2,000||$2,900|
|Subtract 10% of AGI on Personal-Use Property||$0||$8,000|
|Deductible Business Loss||$2,000|
|Deductible Personal Loss||No Dedction|
If property is covered by insurance, but you do not file a claim, then the loss that would have been reimbursed will not be deductible, but the excess loss may be deductible.
Insurance reimbursements for excess living costs, which are incurred because you were forced to leave your home due to extensive damage, are not taxable if the following tests are met:
- your principal residence was destroyed or damaged by fire, storm, or other casualty or you were denied use of the residence by government order because of an impending threat of casualty;
- you were paid for living expenses by insurance proceeds for the loss of the use of the residence.
Only the excess is tax-free, since normal living expenses are not deductible. This exclusion from income taxes does not cover reimbursements for rental income or for the damage or loss of real or personal property since they simply reduce the amount of the loss. This tax-free exclusion also does not apply to the business-use portion of a home. Insurance reimbursements for expenses because of a condemnation or other government order that is unrelated to a casualty is not tax-free. Insurance reimbursements covering normal expenses are considered income, since you must pay those expenses from taxable income regardless.
If the casualty loss exceeds your income, then the loss can be carried back for up to 3 years or carried forward for 20 years. The $100 floor and the 10% AGI floor that applies to personal property is only applied to the deductible portion of the current year and not to any carried back or carried forward amounts.
- The replacement period was extended to 5 years if the destroyed principal residence was in a disaster area caused by Hurricane Katrina, or was located within the 2007 Kansas or 2008 Midwestern disaster areas, but only if the replacement residence was also in the disaster area.