The U.S. is a big country, and recurring natural and manmade disasters are inevitable. This year, we’ve already had tornadoes and wildfires. Hurricane season is about to commence, and forecasters are predicting a busier than average spate of storms. Batten down the hatches. If you’re unlucky enough to suffer a disaster-related loss, here’s what you need to know about the federal income tax implications.
Deductions for personal casualty losses
In theory, the federal income tax rules allow you to claim an itemized deduction for personal casualty losses that are not covered by insurance. A casualty loss occurs when the fair market value of an asset is reduced or wiped out by hurricane, wind, flood, fire, earthquake, volcanic eruption, sonic boom, and the like, or by theft or vandalism.
In reality, however, many disaster victims don’t qualify for personal casualty loss write-offs because of the following two rules.
* First, you can only deduct personal casualty losses if they are due to a federally declared disaster. So, if your house burns down because you accidently left the old space heater in your basement on for three days, you get no tax deduction. Sorry. You can find lists of federally declared disaster areas on the IRS website.
* Assuming your personal casualty loss was due to a federally declared disaster, you must reduce it by $100. No big deal. Then you must further reduce it by an amount equal to 10% of your adjusted gross income (AGI). AGI is the number at the bottom of page 1 of your Form 1040; it includes all taxable income items and selected deductions such as the ones for IRA contributions, self-employed retirement plan contributions, HSA contributions, and student loan interest. The 10%-of-AGI reduction is a big deal.
Say you incur a $40,000 personal casualty loss from one of this year’s disasters and have AGI of $150,000. Your write-off will be only $24,900 ($40,000 – $100 – $15,000). You get absolutely no tax break if your loss before the two required subtractions is $15,100 or less, and you have no chance for a deduction unless you itemize.
But let’s assume you do have a deductible personal casualty loss from a 2022 event after the two subtractions. If the loss was caused by a disaster in a federally declared disaster area, a special rule allows you to claim your rightful deduction on either: (1) your return for 2022 (the year the casualty event actually occurs) or (2) an original or amended return for 2021 (the year before the casualty event). In effect, this beneficial rule allows you to claim the deduction in the year when it does you the most tax-saving good. For example, if your AGI was much lower in 2021 than this year, claiming a 2022 loss in 2021 could result in a much bigger deduction. Plus, if you claim the deduction in 2021, you don’t have to wait until after you’ve filed your 2022 return sometime next year to collect your tax savings.
If you suffered a disaster-related loss last year, you can claim the loss on either: (1) your yet-to-be-filed return for 2021 or (2) an amended return for 2020.
Deductions for business casualty losses
If you have disaster-related losses to business assets, you don’t have to worry about the $100 subtraction rule or the 10%-of-AGI subtraction rule. Instead, you can deduct the full amount of your uninsured loss as a business expense.
As with personal casualty losses, you have the option of claiming deductions for losses that occur in a federally declared disaster area on either your return for the year the disaster occurs or on an original or amended return for the year before.
Beware: you might have a taxable involuntary conversion gain
When you have insurance coverage for disaster-related property damage — under a homeowners, renters, or business policy — you might actually have a taxable gain instead of a deductible casualty loss. Why? Because if the insurance proceeds exceed the tax basis of the damaged or destroyed property (basis is normally equal to the cost of the property, including improvements), you have a taxable profit as far as the IRS is concerned.
This is the case even if the insurance company doesn’t fully compensate you for the pre-casualty value of the property. These gains are called involuntary conversion gains — because the casualty event causes your property or asset to suddenly be converted into cash from the insurance proceeds.
For example, you could have a big involuntary conversion gain if your appreciated vacation home was heavily damaged or destroyed and your insurance coverage greatly exceeded what you paid for the property when you bought it years ago.
If you have an involuntary conversion gain, it generally must be reported as income on your Form 1040 unless you: (1) make a gain deferral election and (2) make sufficient expenditures to replace the property with similar property by the applicable deadline. If you make the election (you generally should when it is available), you’ll have a taxable gain only to the extent the insurance proceeds exceed what you spend to repair or replace the damaged or destroyed property or asset. The expenditures for repair or replacement generally must occur within the period beginning on the date the property was damaged or destroyed and ending two years after the close of the tax year in which you have the involuntary conversion gain.
Beneficial rules for principal residence involuntary conversion gains
For federal income tax purposes, special taxpayer-friendly rules apply to principal residence involuntary conversion gains.
* You can use the principal residence gain exclusion break to reduce or eliminate the involuntary conversion gain. The maximum gain exclusion is $250,000 for unmarried homeowners and $500,000 for married joint-filing couples. To qualify for the maximum exclusion, you must have owned and used the property as your main home for at least two out the last five years.
* If your residence was damaged or destroyed by an event in a federally declared disaster area and you still have an involuntary conversion gain after taking advantage of the gain exclusion break, you have four years (instead of the normal two years) to make expenditures to repair or replace the property and thereby avoid a taxable gain.
* If contents in your principal residence are damaged or destroyed by an event in a federally declared disaster area, there is no taxable gain from insurance proceeds that cover losses to unscheduled personal property (so-called contents coverage). In other words, you need not replace the contents to avoid a taxable gain. You can do whatever you want with that part of the insurance money. Sources: IRC Sec. 1033(h) and IRS Revenue Ruling 95-22.
Example: In 2022 your main home and its contents are completely destroyed by a wildfire in a federally declared disaster area. Later in 2022, you receive insurance proceeds of $600,000 for the home, $100,000 for unscheduled personal property in the home, and $25,000 for scheduled personal property (jewelry and a coin collection). You have no taxable gain on the $100,000 received for unscheduled personal property.
If before the deadline you reinvest the remaining $625,000 of insurance proceeds in a replacement home and any type of replacement contents (whether scheduled or unscheduled, or both), you can elect to postpone any taxable gain that you would otherwise have to report on your Form 1040. If you reinvest less than $625,000, you have a taxable gain to the extent the $625,000 exceeds the amount you reinvest by the deadline. To postpone gain, you must reinvest in replacement property before 2027 (four years after the end of the tax year that you have what would otherwise be a taxable involuntary conversion gain). Your tax basis in the replacement property equals its cost decreased by the amount of any postponed gain under the rules explained in this example.
The bottom line
There you have it: most of what you need to know about disaster-related casualties and your taxes. For more details, see IRS Publication 547 (Casualties, Disasters, and Thefts) at www.irs.gov. For large insurance payments that could result in a sizable involuntary conversion gain, consider hiring a tax pro to deal with all the complicated rules and prepare your return. Money well-spent.