Taxes and Destruction – The Casualty Loss Deduction

While growing up in Redding, California, the disasters rolled around every year like our SimCity god was bored of our typical day to day living. If we didn’t suffer massive flooding and storm damage in the winter, then we could look forward to uncontrolled fires in the summer.

Catastrophic events hit throughout the nation all the time, from the large, federally declared disaster, to the oak tree taking its unexpected revenge by falling on a house. While there are undoubtedly numerous questions to ask about each event, since this is a tax site, we’ll focus on just one: is it deductible?

Very few personal deductions are allowed in the tax code. One of the few and proud is the Casualty and Theft Losses deduction. I’ve covered the Theft Loss Deduction previously. This time, I’ll cover the Casualty Loss Deduction

Casualty Loss Deduction Requirements

In general, you can take a casualty loss deduction in the year that the loss is sustained. If you won’t be able to determine the damage in the year the loss happened, you can take the deduction in a later year when the extent of the damage is known.

For it to be considered in the casualty loss deduction department, the casualty must be due to a sudden, unexpected, or unusual cause. Some types of damage obviously fall into this category, like a flood, hurricane, tornado, earthquake, or sharknado. The government has gone even farther than that, including other unexpected events such as a quarry blast, vandalism, or even a particularly aggressive sonic boom.

that

That sound can knock down a house still blows my mind. If it’s happened to yours, though, you’re probably less impressed.

Note that while ocean waves or sudden flooding are included in the “sudden and unexpected” category, gradual erosion and inundation are not. So if you’re watching that cliff below your house chip away little by little, year by year, don’t expect the government to allow you a casualty loss deduction when the cliffside finally takes down half of your house.

Damage from termites is also not considered sudden or unexpected, and is therefore not deductible.

What About Cars?

When I think personal casualty loss deduction, my mind automatically wanders towards houses. If you car is in a collision, though, it is a casualty loss, and is almost certainly sudden and unexpected, even if everyone has told you that you drive like crap. The IRS’s position is that such automobile damage does qualify for the casualty loss deduction, whether it was due to someone else’s terrible driving or your own (i.e. fault does not matter).

Determining the Loss, Plus a HUGE Asterisk

The amount of the casualty loss deduction will be the lesser of:

  • the difference between the fair market value of the property right before the damage and right after it (i.e. you could have sold you house for $300,000 before the tree fell on it, but with tree included in the roof it’ll only go for $100,000), OR
  • the adjusted basis of the property immediately before the casualty (i.e. your bought your house for $250,000, put in $25,000 of improvements, your adjusted basis is $275,000)

In general, if your property is appreciating in value, like most homes unless you’re living in Detroit, the adjusted basis is lower. If your property is decreasing in value, like the homes in Detroit and most cars, then your Fair Market Value will likely be lower and you’ll use that.

The casualty loss deduction is reduced by two things, one little, and one huge:

  1. Any salvage received. So if you get $400 for your brand new totaled Mercedes, you’ll reduce your casualty loss by that scrap amount.
  2. Any insurance or other compensation received. Here is what prevents most people from taking the casualty loss deduction – if you have insurance money that makes you whole, no deduction is allowed.

A note on the second one: if you do have insurance covering the property, you have to make the claim. I mean, you don’t have to in the grand scheme of things, but you have to if you want to take the casualty loss deduction. The IRS doesn’t want you skipping out on your insurance just so you can take the deduction. Plus, it’d be insane if you did, since you’ll get more money from the insurance than you ever will from the deduction. I’m sure someone has tried to pull it off, hoping to keep their insurance premiums low. But the IRS is wise to your scheming. So don’t do it.

What About Gifts?

If your grandma gives you $10,000 after your house falls apart, it does NOT reduce the amount of your casualty loss deduction. While the gift may be related to the loss in your eyes and your grandma’s eyes, it is not in the IRS’s eyes (which is a good thing).

What if You Have a Gain?

I’m really not sure how this would happen, but let’s just say that for some reason disposing of your casualty property netted you a gain. As long as you take all that money and reinvest it in a replacement property, you don’t need to recognize a gain at this time.

Limitation to the Casualty Loss Deduction

Like with the Theft Loss Deduction I discussed before, there are a couple important limitations to the amount of actual deduction you claim on your return.

First, the weird one: each loss has to be reduced by $100. So if you lose $200,000 due to a casualty loss on your house, you only get $199,900. That $100 has been in place for years and years and does not increase with inflation, making it a really odd tax code “feature.”

After that, there’s a far worse limitation: 10% AGI.

Adjusted Gross Income (AGI), as we’ve discussed before, is basically your income after a few random deductions. It’s line 37 on the 1040 in 2014.

Once you’ve calculated your AGI, multiply it by 10%. Then take all your theft amounts and casualty losses grouped together, less that random $100 deduction for each event. Subtract the 10% number you just calculated.

The resulting number will go on your itemized deduction list.

Example: My AGI is $50,000. A tree falls on my house. After insurance proceeds, I still have a loss of $20,000.

First, my casualty loss needs to be reduced by $100. So I have $19,900 left to deduct. Whatever.

Next, I need to calculate 10% of my AGI. $50,000 x 10% = $5,000.

Finally, to calculate my deduction. I reduce my $19,900 amount by $5,000, which gives me a total casualty loss deduction of $14,900.

If you’re doing the math along with me, it’s pretty easy to see where the Casualty Loss Deduction will disappear if the net loss after insurance proceeds is less than 10% of your AGI.

Filling Out the Form

If you do have a casualty loss, you’ll fill out Form 4684. Personal Loss goes on Section A. Following the instructions will walk you through what I discussed above, ultimately giving you the number that needs to be carried over to 1040 Schedule A.

Questions?

Feel free to reach out to me if you want to know more. Comments below work fine, or @TimJGordon on Twitter.