A casualty is the damage, destruction or loss of property resulting from an identifiable event that is sudden, unexpected or unusual. Taxpayers who suffer an economic loss due to a natural disaster like Hurricane Harvey can claim a casualty loss deduction on their federal income tax return, either in the year of the disaster or the prior year. A loss occurs when the insurance proceeds do not exceed the lesser of the adjusted basis (cost plus improvements, minus depreciation taken) in the property before the casualty or the decrease in fair market value as a result of the casualty. We’re here to simplify the complex tax law and details regarding casualty losses, which can be found in IRS Publication 547.
Example of a casualty loss
Let’s say a home was purchased for $175,000 and you made $25,000 worth of improvements over the years, so your adjusted basis is $200,000. The house was valued at $350,000 before the hurricane. Assuming the fair market value of the home was reduced down to $100,000 then you’d have a reduction in fair market value of $250,000 ($350,000 – $100,000 = $250,000). However, the adjusted basis is less than the reduction in the fair market value so therefore the loss can’t exceed $200,000.
Now lets say the home was purchased for $175,000 with the $25,000 worth of improvements again, so your adjusted basis is $200,000, but it was valued at $250,000 before the hurricane. The damage from the flooding caused the home to be valued at $100,000 so there is a $150,000 reduction in the fair market value. Since the drop in the fair market value is less than the adjusted cost basis then the loss can’t exceed $150,000.
Additionally, it should be noted that any loss should be reduced by flood insurance proceeds received. So if the calculated loss is $150,000 but the insurance proceeds equals $100,000 then there is only a $50,000 loss.
Losses are reported on IRS Form 4684, but there are important limits. The loss must be reduced by any insurance reimbursements or any aid received. In addition, taxpayers can only deduct losses greater than 10% of their adjusted gross income. This number can be found on the bottom of the front page of the federal tax return. After Hurricane Katrina, congress passed a tax relief act that lifted the casualty loss restrictions for the areas damaged by Hurricane Katrina, however they did not do the same for Tropical Storm Sandy. Under current law the 10% rule applies to those impacted by Harvey, and we will continue to closely monitor legislation for any relief that would aid those impacted by the hurricane.
The IRS has prepared Publication 584 which contains helpful logs for each room of the house and typical contents to assist you in identifying your property losses.