There may be errors in spelling, grammar, and accuracy in this machine-generated transcript.
Jeremy Wells: Welcome to another episode of Tax in Action. For this episode, I'm excited to kick off the first multi-part series. This is going to be a three part series that I'm really excited to bring out because, you know, the world's changing in multiple ways, and one of those ways [00:00:30] is that we're seeing more and more frequent big storms, earthquakes, catastrophic events, and those can have serious financial implications for ourselves, for our communities, and for taxpayers at large. And we need to understand the tax implications of that, both for ourselves as well as clients. If you're if you're working with taxpayers. So when disaster strikes, There is [00:01:00] some relief available in tax law, but only if you know the details and the rules of how to claim that. So in this episode, the first of a three part series, I'm going to unpack the rules for casualty losses. In the next part, we're going to look at theft losses. And in the third part we're going to look at involuntary conversions. But for this first part, we're going to focus on casualty losses. And this is when disaster strikes, when [00:01:30] big storms hit, when earthquakes happen. Or it can be just isolated events like fires, car crashes. There are even some cases where maybe a, uh, a single piece of property was just, say, smashed in a car door and that actually qualified as a deductible casualty loss. Now the rules have changed a bit and I'll talk about that in this episode.
Jeremy Wells: But that's going to be the topic here. Casualty losses. We'll talk about what works, what doesn't, [00:02:00] and how to make sure you and your clients can avoid costly mistakes when it comes to getting those tax benefits for these kinds of events. So first of all, want to go over what a casualty loss is in terms of tax law federal tax law. We're going to look at the differences between personal and business casualty loss rules. We're going to look at the different thresholds, the different limitations and the different ways of reporting those. We're [00:02:30] going to look at the special tax treatment for losses from federally declared disaster areas. That's a concept that's become really important to understand over the last few years, especially with Tax Cuts and Jobs Act. So ever since tax year 2018. And then we're going to finally look at how we actually report these losses using form 4684. In order to wrap our heads around this. I want to start off with a case study. Let's look at Jessica, who owns a [00:03:00] small print shop in northern Florida. She operates out of a commercial building that she's owned for over a decade, and she reports that activity on a schedule C, it's a relatively small business, but for Jessica, it's important. In late 2023, Hurricane Ida caused extensive damage to both the building and her printing equipment. Now, this case study is fictional, but Hurricane Ida was a real storm.
Jeremy Wells: Really hit, uh, [00:03:30] Florida in 2023. I live in northeast Florida, so I experienced the the edge of this storm. I didn't have a lot of damage from it, but a lot of people in Florida did. Now, her property insurance in this case only covered the building. The building's basis going to give a little bit of basic information here. The building's basis was about $200,000, but the fair market value, because she had owned it for a while, had gone up to about $400,000. Insurance paid her $250,000 [00:04:00] for the building. She considered the building a total loss, though she only paid for some minimal cleanup and repairs, and she actually decided to go lease a different property instead. This example I'm going to carry forward into, uh, a couple of other episodes in this series, so but I'll remind you of the details here, but it's important to keep in mind that she's only, uh, minimally [00:04:30] cleaning up and repairing this structure, and she's actually decided to move on from it and go work in a different facility. As far as the equipment, that was a total loss. Her basis in that was about $50,000 with a fair market value at the time of the disaster of about $30,000. Again, I'll remind you these details, but it's important to get a real world idea of what we're talking about because our clients or if you're a taxpayer, you're going to have these situations where [00:05:00] this is the kind of information you're going to need at to have at hand and to be able to document when you're dealing with these situations, especially reporting them for tax purposes.
Jeremy Wells: So let's look at what we actually mean by a casualty loss. There are actually three types of casualty losses as far as what's defined as a deductible casualty loss in tax law. The first one is losses that are incurred in a trade or a [00:05:30] business. That's the first type. The second one is losses incurred in any transaction entered into for profit, though not connected with a trade or business. And then third, losses of property not connected with trade or business or transaction entered into for profit. In other words, this is going to be a personal loss if those losses arise from fire, storm, shipwreck or other casualty or from theft. And that all comes out of [00:06:00] IRC section 165 C3. Those are the three kinds of losses that are discussed in that code section. Irc section 165. Here we're going to specifically focus on these casualty losses, both personal and business. And for the purposes of casualty losses, when we're talking about business casualty losses, we're also including those activities that are engaged in for profit, although not necessarily related to a business. And I'll talk more about [00:06:30] what that means later on. Going to save theft losses for the next episode. That's a whole separate set of rules.
Jeremy Wells: And there are some recent developments within the last decade or so that have a lot more complexity and nuance around theft losses and how we calculate those. So you're going to have to wait a couple of weeks to hear about how those work. For right now, we're going to focus on casualty losses. Now, what's important to keep in mind throughout this discussion is that [00:07:00] the Tax Cuts and Jobs Act of 2017, which really came into force with tax year 2018, eliminated the deduction for personal casualty losses, except for those losses due to a federally declared disaster. Again, I'll talk more about what that means later on. Now back to this question of an activity engaged in for profit. What do we mean by that? Because it's fairly straightforward, [00:07:30] although at times there can be some nuance there. But it's usually fairly straightforward to talk about an activity being a trade or a business. And then on the other hand, if it's not that, then it's typically personal. But somewhere in between lies this category of activities that are engaged in for profit. So really, we don't have a clear definition of what that means in the actual law or even regulations. But what we do have is case law that's developed over time, that [00:08:00] considers whether the taxpayer's predominant, primary or principal objective in engaging in the activity was to realize an economic profit independent of tax savings. That's the definition that has originated out of case law, and is now part of the precedent of looking at whether these losses are, in fact, deductible as an activity engaged in for profit, or whether it's a personal [00:08:30] casualty loss.
Jeremy Wells: Some of the factors that are looked at that would indicate this profit motive, uh, include the list that are in Treasury Regulation 1.183 to be B. One. 83. Section one. 83. In the Internal Revenue Code is all about activities engaged in not for profit. And so it's really sort of a definition by by that negative not for [00:09:00] profit activities. And from that we can get an idea of what might be an activity engaged in for profit. So some of the other criteria that we're looking here, looking at here are the taxpayer's expertise, the taxpayer's reliance on qualified advisors, whether the taxpayer has had any success in similar activities and then the taxpayer's financial status. So a lot of times when we're dealing with these activities engaged [00:09:30] in for profit, we're looking at situations where taxpayer has usually invested into some sort of venture. So the taxpayer is not directly involved. The taxpayer doesn't actively participate in the venture as a co-owner or a partner or a manager. Rather, they just invest in the activity and hope to get some profit out of it. So a lot of investment clubs. Some of these, uh, limited partnership type [00:10:00] activities, these taxpayers might be engaging in them for profit and not necessarily just for the tax benefits of them, although that's usually a key part of why they get involved in them.
Jeremy Wells: And a lot of this case law hinges on whether the taxpayer was just pursuing the tax benefits of the transaction, or whether the taxpayer was actually concerned with getting profits back out of this activity. But no single factor [00:10:30] or even group of factors determines whether or not a taxpayer engages in an activity for profit. We really have to look at the entire situation. That's what the courts have told us. And there's one particular tax court case this is done versus commissioner. This is a 7715. This case out in 1978 was actually affirmed in the Second Circuit. And so from this, what we get is this idea of what it means to be engaged in an activity [00:11:00] for profit. Now, if we're talking about casualty losses or in the next episode, we'll talk about theft losses. This is actually a critical distinction because as I said before, especially now under Tax Cuts and Jobs Act, for tax years 2018 through 2025, those personal casualty losses are not going to be deductible unless they're related to a federally declared disaster. So if you have some sort of casualty loss in some activity, that's [00:11:30] generally not going to be deductible if it's personal, unless it's some sort of storm or significant Efficient disaster, such as an earthquake, that that really just wipes out your entire community or region.
Jeremy Wells: Otherwise, that activity is a full blown trade or business. Then that casualty loss is more likely to be deductible. It's these activities that are somewhere in between. Passive investments [00:12:00] are one of these types of events. And so the courts have really looked seriously as to whether these activities, whether the taxpayers really actively were engaged in them in order for, uh, making a profit or whether they were just pursuing some sort of tax benefit out of them. Now, when we're looking at a casualty loss, we have to look at, uh, three different criteria in order to determine whether it's [00:12:30] going to be a deductible casualty loss. The first one is that there has to be some sort of damage destruction, or loss of property. Theoretical losses or potential losses don't qualify. And again, this is coming out of case law where taxpayers have attempted to claim potential losses or possible losses or anticipated losses due to some local event or some sort of economic change, [00:13:00] and from that actually deducted a loss based on what they anticipated or expected a future loss to be based on that. The courts have found that that doesn't work there. There has to be some sort of actual damage, destruction, or loss of physical property in order to qualify. Some of those cases look something like mudslides in the area that didn't actually destroy the taxpayer's home, but [00:13:30] rather significantly brought down the property values in the area.
Jeremy Wells: And so something like that. Even though there's going to be a significant economic and financial impact on the taxpayer, that's not actually going to qualify as a deductible casualty loss because there's been no damage, destruction or loss of property directly to the taxpayer yet. So if you have one of these potential losses, or you're working [00:14:00] with a taxpayer that is claiming that there's a loss because of changes in the area's housing market or economy, for example, those aren't going to fly. The second criterion that we're looking at here of a casualty loss is that it results from some identifiable event. This is critical also. Uh, we have to be able to point to a specific event. It needs to be some sort of storm [00:14:30] crash. Check. Earthquake. It needs to be something that we can actually point to, and it's finite in time. It can't just be ongoing. Uh, an ongoing period, such as a recession, which might last several years. Even an ongoing war is an example of a situation where this is even though it's an identifiable event. We might refer to [00:15:00] this war. If it's a war that has lasted several years, then that's not necessarily an identifiable event. If there was, for example, an invasion of a town or a community, or a terrorist attack of that city that resulted in the specific destruction of property, then that could be an identifiable event. And actually, there's a kind of interesting tax court case where the taxpayer [00:15:30] won one against the IRS because the taxpayer claimed that the his home in a Vietnamese village was lost because during the Vietnam War, the North Vietnamese invaded that village, and that, uh, taxpayer then had to evacuate the town and move back to the states.
Jeremy Wells: And so that was actually a loss deducted on that individual's tax return. Irs wanted to deny [00:16:00] the loss, and that ended up being a tax court case. So there are these situations which might seem far fetched, which might seem, uh, like, uh, there's something that really would never happen to us, but there there are cases where they do happen, and we need to be able to understand what the implications from tax law perspective of these kinds of events are. And then finally, not only is that an event identifiable, but it also has to be sudden, Unexpected and unusual [00:16:30] in nature. Now, when you combine that identifiable event with the fact that it is sudden, unexpected, and unusual in nature, that eliminates a lot of what we might consider normal wear and tear, for example. So if you have a vehicle or a building and just over time through normal use, the parts begin to wear out, the look of it begins to wear out, it begins to fall apart. And then one [00:17:00] day, either that vehicle's engine just won't start anymore, or it's not safe for the road, or that building is no longer structurally sound and safe to live in because it hasn't been repaired, it hasn't been maintained.
Jeremy Wells: That is not a casualty loss that's happened over time. It's not an identifiable event. It's not sudden. It was probably expected if you failed to maintain it. Um, and it's definitely usual for normal wear and tear to happen over time. So those kinds of things are not going to qualify as casualty [00:17:30] losses. So again, damage or destruction or loss of property resulting from an identifiable event which is sudden, unexpected and unusual in nature. That's the definition of a casualty loss. And that comes from revenue ruling 70 to 592. So if you have a client that's in a situation, or if you're a taxpayer in a situation where this might apply to you, I recommend looking at that revenue ruling. So even though it's a more than 50 years old now, it still gives us the definition of what is [00:18:00] a potentially deductible casualty loss. It has to meet those three criteria again, a decline in value due to fear of potential events, but no actual damage doesn't qualify as a deductible casualty loss. For example, a decline in a home's market value due to a fear of recurring floods or landslides in the area. But it's not caused by an actual flutter. Landslide is not going to be deductible as a casualty loss, [00:18:30] and there's some specific case law that supports this position. And then that casualty has to result from an identifiable event in revenue.
Jeremy Wells: Ruling 59 102. There is an explanation of what an identifiable event means. So there must be a provable event which not only has a causal relation to the decline in value of the damaged property, but can [00:19:00] be isolated from other events or sequences, leading to changes in value in the damaged property. The primary significance of the latter requirement is that generally, the amount of a casualty loss deduction is in part determined with reference to the value of the property before the casualty and its value immediately after the casualty, so that it's necessary to fix a time at which the casualty took place. That's from revenue ruling 59 102. [00:19:30] We'll talk about this in a minute. But the the way we calculate the actual casualty loss in financial terms is based on the difference between the fair market value of that property immediately before and immediately after the casualty event. If it's not possible or easy to identify when that event occurred, then we're not [00:20:00] going to know what the value of that property was immediately before and immediately after that event, because we're not going to be able to identify that event. And so if we don't insist on having this easily identifiable event, then our entire formula for calculating that loss begins to fall apart. So it's critical that we're able to identify that event. Now, in terms of personal casualties, uh, especially under Tax Cuts and Jobs Act, it's fairly straightforward because we're only looking [00:20:30] at federally declared disasters.
Jeremy Wells: If the federal government recognizes an event as a federally declared disaster, in that case, we understand what the identifiable event is. Federal government has already identified that event. In the case of business losses or other, uh, casualty losses, it might be more difficult. It might be more difficult to pinpoint a specific event that occurs within just a few hours or a couple of days. We might have to make a determination [00:21:00] over whether this is something that was building up over time, or something that was a specific event. And then finally, that casualty must be sudden, unexpected and unusual. From revenue ruling 72 592. We get a definition of those three specific terms. So sudden means swift and precipitous, not gradual or progressive. Again, we're not looking at normal wear and tear over time. We're looking at something that is a specific event in time and do specifically [00:21:30] to that event. We have that, uh, damage, destruction, uh, to that property. Unexpected means ordinarily unanticipated and occurs without the intent of the one who suffers the loss. So there's two parts to this with unexpected, first of all, ordinarily unanticipated. And I think not to, uh, I'm no meteorologist or climatologist, but I live in Northeast Florida. [00:22:00] Hurricanes. We have a season where we just kind of wait for hurricanes to strike. And so whether that hurricane is actually going to form and whether it's actually going to hit your specific area, that's still fairly unanticipated.
Jeremy Wells: We spend a lot of time when you live in Florida watching the weather during the summer, especially the late summer and early fall, watching these tropical storms, watching these hurricanes develop out in the Atlantic [00:22:30] and the Gulf, waiting to see if they're going to turn and start heading toward your community. That is still at the level of being ordinarily unanticipated. We know that hurricanes can and will strike. We just not sure when or where. And then the second part here is without the intent of the one who suffers the loss. You can't create your own laws. Uh, in and I'm not an attorney. [00:23:00] I don't know what the law says, but I know that there is criminal law that deals with trying to intentionally destroy your own property in order to, for example, collect the insurance. That's usually some form of fraud at the same time. You can't use that kind of event, that kind of forced loss and try to get a tax benefit out of that. And then finally, unusual means extraordinary and [00:23:30] non-recurring does not commonly occur during the activity in which the taxpayer was engaged when the destruction or damage occurred, and does not commonly occur in the ordinary course of day to day living of the taxpayer. Again, I live in Florida. Hurricanes happen. They don't happen all the time.
Jeremy Wells: They happen every now and then. So they're becoming more frequent. They're becoming more powerful. They're still pretty unusual in day to day life. So [00:24:00] let's look back to Jessica's case here. Remember, Hurricane Ida hit Jessica's small print shop business. Her losses were the result of a hurricane. Hurricanes are a type of storm, and a storm is a specific type mentioned in IRC 165 C3 as a specific kind of casualty. Also, and we'll talk about this more in a minute. But on August 30th, 2023, the IRS announced relief for taxpayers affected [00:24:30] by that hurricane following a disaster declaration issued by the Federal Emergency Management Agency or FEMA. And so in that case, not only do we have a hurricane, which is a storm, which is a specific type of casualty event mentioned in the code section, but we also have that federal declaration of a disaster area. And that is what specifically helps us identify that as a casualty event. It's also [00:25:00] going to help Jessica meet the requirement for the casualty losses. Now in her case, it's a business. If we were talking about her personal property, if it were her home or her vehicle, or some of her personal property that she had in her home, then we would be talking about personal casualty losses. And because this was a federally declared disaster area, this would still make it, uh, deductible, potentially deductible [00:25:30] for her even under Tax Cuts and Jobs Act. So now let's look at how we actually determine those casualty losses or gains.
Jeremy Wells: And it's entirely possible to wind up with a casualty gain. So first of all, casualty gains or losses depend on two things. First of all is the cost or adjusted basis in the property that is destroyed or damaged as a result of that casualty event. And then the second [00:26:00] is the change in fair market value. So we need to know the following information. Whenever we're looking at potential casualty losses, the cost or adjusted basis of that property. The change in the fair market value. The fair market value immediately prior to and immediately after the event. We need to know both of those amounts, and then we also need to know if there's any insurance or reimbursement [00:26:30] received or expected. As a general rule, a casualty loss is calculated as the lesser of the adjusted basis or change in fair market value minus any insurance or reimbursement that comes from Treasury Regulation 1.1657. So again, if you're a taxpayer or if you're working with taxpayers who have suffered casualty potential [00:27:00] casualty losses or have, uh, lived through a casualty event, then that's the information you're going to need to have on hand for that event. The cost or adjusted basis of any property that's been damaged or destroyed. The change in fair market value, meaning the fair market value both before and after that event. And then whether any insurance reimbursement was received or expected.
Jeremy Wells: Now, the fair [00:27:30] market value before and after the event might be difficult to get. People don't usually see that. For example, a hurricane is about to strike and then go hire an appraiser to appraise all their property. How do we know what the fair market value of property was immediately before a casualty event? We might have even more unexpected events, such as earthquakes or fires, for example. It is possible to get [00:28:00] some, uh, estimates. And one of those can be the cost of the repairs as evidence of the change in value of the property. So replacement cost or cost of repairs generally don't equal fair market value. And this is important to keep in mind. Just because a taxpayer spends a certain amount of money to repair or replace a piece of property doesn't necessarily mean that we've established [00:28:30] the fair market values before and after the casualty loss. However, you can use the cost of repairs as evidence of the loss in value if all of the following criteria apply and these come out of Treasury Regulation 1.1657. First of all, the repairs were necessary to restore the property to its condition immediately before the casualty. This helps ensure that we're actually repairing and restoring [00:29:00] that property to its condition immediately before the casualty, and we're not using this as an excuse to improve that property beyond its state or condition before the casualty. The amount spent on the repairs is not excessive.
Jeremy Wells: Uh, is another criterion. Third, the repairs only correct damage caused by the casualty. We're not repairing the, uh, disrepair or the wear and tear that was resulting [00:29:30] before the casualty. We're actually bringing it back up to the condition that it was just immediately before the casualty. So if it's a piece of property, whether that's a building or a vehicle or something else, some piece of equipment or machinery that was already, uh, so it had experienced some wear and tear before the casualty event, then the deductible portion or the potentially deductible portion of the repairs that we can use here in order to calculate that change in fair market [00:30:00] value, is just what it takes to get it back to its condition immediately before the casualty. And then finally, the repairs do not increase the value of the property beyond its value immediately before the casualty. So really, these are four separate criteria that are listed in Treasury regulation. But they're all kind of getting at the same thing. We need to restore this piece of property to what it was immediately before the casualty, and not improve it even further beyond what that state or condition was. And [00:30:30] then this is a critical point because I mentioned insurance or reimbursements earlier. Now there are cases where you might experience some sort of casualty loss, but, uh, you or the taxpayer may not want to get insurance involved. For example, uh, a car crash.
Jeremy Wells: In a car crash, you might have just a little bit of damage to the vehicle. And other than some cosmetic damage, [00:31:00] or a bent fender, for example. Maybe there's really no reason to get insurance involved. Um, and the repairs aren't necessary, especially if it's an older used vehicle. And so you might just say, well, let's leave insurance out of it and then attempt to claim, uh, some sort of, uh, casualty loss deduction. That's not going to work because a taxpayer cannot claim a casualty [00:31:30] loss unless she files a timely insurance claim. So there are two parts to this. First of all, in order to calculate the actual casualty loss, we have to take into account the insurance claim that is actually received or expected and expected. Includes could be claimed. So if there's a potential insurance claim whether the taxpayer actually claims it [00:32:00] or not. We still have to include that in the calculation of the casualty loss. But, uh, and this was added to IRC 165 by Congress in the mid 80s, we actually go a step further and say that in order to be able to claim that loss at all, the taxpayer has to file a timely insurance claim. Now, specifically in Congress's explanation [00:32:30] of why they added this, uh, part to the tax code, Congress said the deduction for personal casualty losses should not be allowed only when a loss is attributable to damage to property that is caused by one of the specified types of casualties, that that deduction should be allowed only when that loss is attributable to damage, where the taxpayer has the right to receive insurance proceeds that would compensate for the loss.
Jeremy Wells: The loss [00:33:00] suffered by the taxpayer is not damage to property caused by the casualty. Rather, the loss results from the taxpayer's personal decision to forego making a claim against the insurance company. So that was Congress's justification for adding that requirement to file a timely insurance claim in order to claim the casualty loss. And this is coming out of the House's report, number 99, for 26, back in 1985. And this created [00:33:30] an IRC section 165 H5. And that's where we get the rule that the taxpayer has to claim that file, that that timely has to make that timely insurance claim. Now insurance can deny the claim. The claim can only be partially fulfilled. Uh, and timely filing that insurance claim is actually pretty loosely interpreted in the court. So there is some court precedent [00:34:00] around what that actually means in practice. But in order to be able to claim that loss, that insurance claim has to be filed. So again, in terms of the information that you need to have on hand, if you suffered the casualty loss, you need to have that insurance information and probably a copy of that claim that you filed on hand. And if you're working with taxpayers, you need to make sure to request that and get that information from them, because you won't be able to file the, uh, [00:34:30] loss on the taxpayer's tax return without showing that that claim was actually filed.
Jeremy Wells: And then the taxpayer, uh, won't be you won't be able to calculate the taxpayer's loss without including that, uh, even potential insurance claim amount. There are also a few safe harbors. Uh, and this comes out of rev proc 2020 1808 Revenue Procedure 20 1808. [00:35:00] In 2017, there were a few significant storms, three hurricanes in particular that caused pretty significant and widespread damage, uh, especially in terms of personal losses. And so the IRS put together this revenue procedure in order to provide some safe harbors, to make it easier for people to calculate what their losses actually were. And again, because not [00:35:30] everyone can rush out and get an appraisal of their property as a hurricane is bearing down on their community, or as an earthquake is about to happen, there needs to be some way of being able to estimate what that change in fair market value is. And that's what these, uh, safe harbors in this revenue procedure, uh, help us with so estimated repair costs. Uh, is one potential safe harbor here. As long as the taxpayer gets two, uh, [00:36:00] qualified repair estimates and takes the lesser of those two estimates, that provides a safe harbor for calculating change in fair market value. Uh, another one is the de minimis for real property safe harbor.
Jeremy Wells: This is a good faith estimate of up to $5,000. $5,000 is probably not going to be very much, though, especially if you're dealing with a major catastrophic event such as a hurricane, uh, or forest fires that have been declared [00:36:30] a federal disaster area. So the de minimis safe harbor might only get you so far, especially when it comes to real property. There's also a de minimis safe harbor for personal property, which is also a good faith estimate of up to $5,000. Insurance is another provide can provide another safe harbor. And so the estimated loss determined by your insurance provider, as long as that is a reasonable estimate and it's provided by a [00:37:00] qualified insurance provider, then you can rely on that as a safe harbor and independent contractors. Price can also serve as a safe harbor, but only in a federally declared disaster area. Um, so even if we're talking about, uh, a casualty loss, that might be the result of, uh, something that isn't in a federally declared disaster area, then that safe harbor in particular is not going to work. But all of these safe harbors [00:37:30] are only for personal property only. So at least for 2018 through 2025, we're only talking about federally declared disaster areas now after 2025, uh, this could be all up for grabs again. And as we, uh, as as personal casualty losses become deductible again for individuals. A disaster loan appraisal can provide another safe harbor, as long as that's an appraisal from a federal or federally backed loan.
Jeremy Wells: And then [00:38:00] finally replacement cost at the reduced market cost. There's there's a formula in the revenue procedure and there's a way of calculating this. It's essentially taking the replacement cost of a piece of property and then reducing that by a percentage based on how old the damaged or destroyed property is. So the older the damaged or destroyed property is, you take a smaller percentage of the replacement cost for [00:38:30] the new property that can provide a safe harbor as well. Although if you're talking about replacing property that's more than a few years old, that percentage declines pretty rapidly. So those are all some safe harbors that are available for personal casualty losses. None of those apply to business casualty losses or for activities engaged in for profit. But as far as personal casualty losses, those might be a helpful way of estimating, especially the repair costs and that independent [00:39:00] contractors price. So if you want to take advantage of one of those safe harbors, make sure you get that information. Try to get two different repair estimates. That might be difficult in an area that's just been hit by a major disaster. It might be difficult to get two different, uh, companies or crews to come by and give you estimates, but that can provide a safe harbor to calculating, uh, the losses. Other than that, [00:39:30] getting that qualified independent contractors price, uh, might be the way to go.
Jeremy Wells: And then, of course, you can also rely on your, uh, insurance adjusters evaluation of the situation Now, once we have these casualty losses and we've got the information we need, how do we report them? The first question is when do we report the casualty loss. And of course, generally the rule is that the taxpayer reports and deducts the casualty loss [00:40:00] only in the tax year in which the casualty loss occurred. That just makes sense. So in Jessica's case, if the storm hits in 2023, she's probably going to report that loss on her 2023 tax return. Now, there's an important exception to that that I'll talk about here in a moment. And this is going to be true even if the taxpayer does not repair or replace the property until a later year. That comes from Treasury Regulation 1.1651. It's important to keep this in mind, [00:40:30] too, because especially if you have a significant disaster. And so repair crews and independent contractors are stretched thin throughout the area and they're not able to get around to all of the sites, uh, immediately. Or if you've got a disaster that hits particularly late in the year, and it's not until the following year that those repairs or replacements are actually able to be made. In either case, you're still going to take that [00:41:00] deduction generally in the year that the casualty occurs. This can make it a little difficult though, in order to actually calculate the amount of the loss.
Jeremy Wells: Because if you haven't repaired or replaced anything, how would you know the cost to do that? In order to calculate, uh, potentially use one of those safe harbors, for example, uh, or use repair costs as an estimate of the change in fair market value. Well, that's something you as [00:41:30] the taxpayer or you as the tax advisor, the taxpayer would have to, uh, figure out. So you would either need to wait until those repairs had actually been made. And this is part of the rationale behind deadline postponements, which is a topic I've talked about on this show before in a prior episode. Um, but those postponements can help provide a bit of time in order to get that information together. It might not be enough time, [00:42:00] uh, though. And so in those cases, you might want to, uh, file that automatic six month extension of time to file, for example. But in those cases, uh, you'll have to wait until the repairs are actually made or until you get, uh, enough information to be able to calculate what that casualty loss actually is. Now, in a disaster area, there is a special election [00:42:30] available to taxpayers to elect to deduct a casualty loss resulting from a federally declared disaster in the year immediately prior to the year of the disaster. The election is due six months after the federal income tax filing deadline for the disaster year.
Jeremy Wells: Without regard to any extension, the taxpayer can also revoke that election within 90 days after that date. So let's say it's a normal tax [00:43:00] year where the filing deadline is April 15th, and we're not going to take a six month extension into account. That doesn't count. Here we're looking at an original filing date of April 15th. That taxpayer has until October 15th of that same year in order to make the election to report that disaster loss on the prior year. So that would actually be two years prior to that. So let's say this disaster happens [00:43:30] in 2023, uh, as the as Hurricane Ida hit, uh, Jessica and her property, so Jessica would normally file her 2023 tax return on April 15th, 2024. She has until October 15th of 2024 to elect to report that casualty loss on her 2022 tax return. Now, why would you do this? I think that this helps [00:44:00] accelerate, uh, the refund if you actually have a deductible loss, uh, then you could go back and you could report that loss on a prior year return. You could make that election in order to do that and then claim the refund, uh, from that prior year. And that would provide some cash, assuming you could get that refund. Now, the way you would do that is by filing an amended return, assuming you had already filed that prior year return, uh, then [00:44:30] you would need to file an amended return to add that casualty loss onto it.
Jeremy Wells: I'll talk about form 4684 in a minute, but there's a section of that form where you actually make that election when you're when you're claiming that. So you would amend that prior year return, prepare form 4684. Make sure you filled out the information for that election, and you would file that with the prior year return, and then you would not file that with the [00:45:00] current year. Um, or if you're not going to make that election, you would just file the form with your current year, uh, the return that you're currently working on. The taxpayer can also file an amended return to revoke that election to claim the deduction in the prior year. This is all coming out of Treasury Regulation 1.165 11. Uh, the rules of how to do that are there now in order to, uh, report this casualty loss, we need [00:45:30] to confirm some information. First of all, we needed to determine whether the property is personal use, property or business or income producing property. And then second, for personal use property from 2018 to 2025 under Tax Cuts and Jobs Act. We also need to make sure that that loss is due to a federally declared disaster. And the way we can do that is there's two ways. One, we can go directly to the Federal Emergency [00:46:00] Management Administration or FEMA, and we can search for that event.
Jeremy Wells: And if that event was actually declared as a disaster, then there will be what's called a doctor or an EMT number. So what that looks like is FEMA will issue the declaration and there will be a number assigned to that event, and it will start with doctor or M. The second way is usually once [00:46:30] that has happened within a couple of business days. After that, IRS will also issue a notice, usually providing some sort of relief for that area. And in IRS notice there, uh, they will also, uh, cite that doctor or M number issued by FEMA. So that might be, uh, an easier way to get it, because then you'll also see all of the relief that is available uh, issued by IRS. So [00:47:00] in this case, Jessica used the property. She used the building equipment exclusively in a print shop. So it is business use property. And FEMA did issue a disaster declaration on August 28th, 2023 for Hurricane Ida. The disaster declaration number is doctor 3596M. So that's an example of what that doctor number will look like. Uh, doctor 3596E that is specific to Hurricane Ida. Dahlia. And when you go [00:47:30] to fill out the form 4684 for casualties and thefts above line one, you will actually enter that, uh, FEMA declaration number. Uh, that doctor or Em number goes above line one for personal losses for tax years 2018 through 2025. That's going to be necessary to report that because without that number, if that wasn't a federally declared disaster area, those personal losses aren't going to be deductible. [00:48:00]
Jeremy Wells: Now, it won't be necessary for business or income producing losses, but it will be necessary for those personal casualties. And then in that form, 4684 section A is for personal use property. Section B is for business and income producing property. For mixed use property, you're going to have to figure out a way to allocate the cost, the change in fair market value, and the insurance or reimbursement between the personal and business use of property. If you have that [00:48:30] mixed use property. So for example, if it's a piece of real estate that is used both for commercial and residential purposes, or if it's a vehicle that is used both for business and for personal use, you would need to allocate the loss for both personal and business. That might be especially important if you're dealing with a loss to a piece of property that is not involved in a federally declared disaster area. You might be able to allocate some [00:49:00] of that loss to business use and then actually make it deductible. But keep in mind that the personal use of that asset would not be deductible unless that casualty loss is caused by a federally declared disaster. So what's common between both section A for personal casualty losses and section B for income producing or business property is that you're going to start with the cost or adjusted basis.
Jeremy Wells: You're [00:49:30] going to determine if insurance or reimbursement then produces a casualty gain. So if the insurance or the reimbursement exceeds the cost or adjusted basis, then there's actually a capital gain. Excuse me a casualty gain. And at that point you stop. You stop with the calculation for that piece of property. Now if you have multiple pieces of property that are all part of the same casualty event, there are actually columns in form 4006, 84 and both of these sections. And you'll use a [00:50:00] column for each piece of property. So it's possible that for a piece of property there is actually a casualty gain. If that insurance reimbursement exceeds the cost or adjusted basis, then you're going to calculate the change in fair market value due to the casualty. You're going to use the repair costs or one of those safe harbors I mentioned earlier. And then you're going to take the smaller Mahler of basis or change in fair market value, and then reduce that amount by the insurance reimbursement allowed. [00:50:30] And then you're going to do that for each property and take the total for the entire casualty event. So if there is a gain based on the insurance or reimbursement, you're going to stop. If there is still a loss even after the insurance or reimbursement based solely on the cost or adjusted basis, then you're going to do the change in fair market value calculation.
Jeremy Wells: You're going to take the lesser of that or the cost or basis. And then from there you're going to determine if there is a loss even after the insurance [00:51:00] or reimbursement. So for personal property, we have to do some extra calculations though for business or incoming income producing property. That's it. That that is when we know whether we have a casualty gain or loss for personal casualty losses, we have to do a little bit extra work. First of all, we're going to reduce the loss by $100 for the event. So after we've netted the loss or gains from the individual properties, then we're going to reduce that by $100, [00:51:30] except for a 2016 disaster area. Then it's reduced by $500. Although at this point we're pretty far past 2016. But just in case that comes across your desk, $500 for a 2016 disaster area. Otherwise, it's $100. Now, married couples filing jointly will reduce each loss by that same $100. Couples filing separately will each reduce their losses by $100. [00:52:00] So married couples filing jointly only have to reduce the total casualty loss by $100. A couple filing separately, each individual on their separate return will still have to reduce by the same $100. They don't split that $100, they each reduce by $100. And then after the $100 reduction, the taxpayer nets the casualty gains and losses. If gains exceed losses, then they report the net gain on schedule D. If losses [00:52:30] exceed gains, then they reduce the net loss by 10% of adjusted gross income and then enter the loss on schedule A line 15.
Jeremy Wells: And so that casualty loss winds up being an itemized deduction. Now, it's entirely possible after the netting of gains and losses, then the reduction by $100, then the reduction by 10% of adjusted gross income. It's entirely possible that there is still [00:53:00] some casualty loss there, but then it's going to be an itemized deduction. And with the increased standard deduction under Tax Cuts and Jobs Act, it's going to be interesting to see whether that actually results in being able to take the deduction. So there are some hoops to jump in order to be able to claim that personal loss. And I've dealt with some situations, especially working in Florida with some Florida taxpayers, where they had a relatively significant loss. But because of that calculation, they didn't really see much [00:53:30] of any tax effect from that. And that can be frustrating. That can be disappointing. But sometimes that happens and that's the way that calculation goes unfortunately. And again, if there is a gain due to insurance or reimbursement, then that's actually going to come as a capital gain. And depending on the property, uh, and the time that the taxpayer owned that property, that's either going to be a short term or a long term capital gain reported on schedule D for business casualty gains or losses, [00:54:00] that's going to go on form 4797.
Jeremy Wells: And from there it's going to flow into the tax return as it normally would, unless the taxpayer isn't required to file form 4797, in which case it's going to go directly to where the result of that form would normally flow. And then as corporations and partnerships are going to report that gain or loss according to the instructions for form 4684. So wherever it will go on those pass through entity returns, you're going to need to look at the instructions for [00:54:30] form 4684. And as always, depreciable property may be subject to recapture, so don't forget to include that in your calculation. If there's been depreciation on that property, then you're going to need to use the calculation on form 4097 to calculate the recapture amount, which is going to be ordinary income to the to the taxpayer. So in terms of the case study with Jessica here, remember that she had an adjusted basis in her building of $200,000 [00:55:00] and insurance paid her $250,000. That results in a gain of $50,000 for her. And then the storm rendered the equipment useless, so it reduced its fair market value from $30,000 just prior to the hurricane, to $0 after that is a loss of $30,000. She had more basis than that, and she did not get any any reimbursement or any insurance for that. So the net result, the $50,000 [00:55:30] gain from the building and the $30,000 loss from the equipment is actually a casualty gain of $20,000.
Jeremy Wells: She's going to report that on form 47, 97, or if she's not required to file that on schedule one. So whenever disaster strikes, to sum all of this up, you need to know the following information for casualties. Whether the event is a federally declared disaster area or not. That's especially critical now, [00:56:00] especially if we're dealing with personal property losses, the cost or the adjusted basis of that property, the change in the fair market value of the property, either from an appraisal or from one of those safe harbors. If we're dealing with personal property and the amount of any reimbursement or insurance, regardless of whether that was actually received, whether it's just expected or even if it's unclaimed, you still need to know what the amount of that potential reimbursement or insurance [00:56:30] is. Now, if you live in or work with clients in disaster prone areas, take precautions and keep this information safe and available. Uh, a lot of accounting firms have still have physical records or records that are kept on servers in their offices. And a lot of firms, especially in these disaster prone areas, have had to deal with over the years some of these storms hitting and losing their clients records because they live in these [00:57:00] disaster prone areas, and they've kept them either physically or on servers in their offices. So this is a strong case for moving those records into the cloud, digitizing those records, if they're physical, if they're if they're actually on paper.
Jeremy Wells: And then once they're digital, storing those in the cloud or at least backing them up to the cloud, if you're keeping them on some sort of local server. Please tune in for the next part. In the meantime, if you found this episode valuable, please, [00:57:30] uh, review, uh, write a review, leave a comment on, uh, your podcast player of choice. Especially if you listen in, uh, Apple Podcasts. Uh, that will help boost this show and get it in front of people who are looking and needing good tax content in their, uh, podcast subscriptions. This is part one in this series covering casualty losses. The next two episodes are going to cover theft losses and involuntary conversions, [00:58:00] theft losses. We're going to talk about Ponzi type schemes. I'll also cover the rules around digital assets such as cryptocurrency, and what happens when those are stolen, frozen, or even become worthless. So if you invest in or work with digital asset investors, you'll definitely want to listen to that episode. And then in the third part, I'll cover involuntary conversions. And this is where the tax code actually allows taxpayers under some situations to be able to defer some of [00:58:30] those gains due to casualties, thefts or other similar events. So, uh, as far as Jessica's case, where she actually winds up with that casualty gain after the hurricane, had she done things a little bit differently, she might have been able to take advantage of that involuntary conversion, uh, tax strategy. And I'll talk more about that in that third episode of the series.