By Marc Pounds, CPA Pisenti & Brinker
Sadly, this is the message many tax advisors may be communicating to their clients in the aftermath of one of the most devastating wildfires in Northern California history.
Fortunately, there are a number of ways to avoid this result with proper planning and understanding of the tax law.
The United States experienced an unprecedented series of natural and some may say man-induced disasters in 2017
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- Hurricanes’ Harvey, Irma and Maria
- Northern California wildfires
- Southern California wildfires
This article focuses on the tax issues specifically related to the Northern California wildfires
Casualty vs Disaster
For 2017 and years prior, casualty losses were deductible after applying certain limitations. Disaster losses – those declared to be disasters by the President – are treated more favorably.
Normal casualties – tree falls on your car – a stove top kitchen fire results in lost kitchen – these are subject to two limitations: the loss is reduced by $100 per casualty, and the loss is deductible only to the extent the loss exceeds 10% of Adjusted Gross Income (AGI). Only taxpayers who itemize their deductions can claim a casualty loss.
Disaster losses in 2016 and 2017 – Federal disaster victims can claim a disaster loss even if they use the standard deduction instead of itemizing.
The $100 per casualty reduction is increased to $500 per casualty
The 10% of AGI limitation is waived.
For 2018 and future years, only disaster losses are deductible for federal tax purposes. California still allows non-disaster related casualty losses.
Computing Gain or Loss
A casualty/disaster loss is computed in the following manner: Subtract insurance proceeds from the lesser of the following:
- The reduction in fair market value of the property as a result of the event, or
- The adjusted basis of the property.
If insurance reimbursement is greater, there is a gain instead of a loss.
There are several methods of computing the fair market value before and after the disaster and generally the burden is on the taxpayer to prove both values. However, the IRS recently released several safe harbor methods which may be used to determine values before the disaster, such as: Utilizing repair estimates by licensed contractors; taxpayer determined estimates for De-Minimis losses less than $5,000; values based on replacement cost reduced by 10% for each year owned; and appraisals for obtaining federal disaster loans are just some of the options available.
Example
Rob’s Fountain Grove personal residence before the fire had a fair market value of $1,100,000. The home was completely destroyed by the fire, leaving only land valued at $300,000. Rob paid $500,000 for his home in 1995, including improvements over the years. The personal contents were valued at $200,000 including priceless memorabilia and appreciated artwork that altogether cost $100,000. Rob is still working with his insurance company to arrive at a settlement but he estimates he will receive $900,000 in insurance for the home and $80,000 for contents.
Rob has a gain of $400,000 on the destruction of his home because the insurance of $900,000 is greater than his cost of $500,000.
Rob also has a loss of $20,000 on the destruction of personal contents because the insurance was less than his cost and cost was less than the reduction in fair market value.
Rob has a few options to avoid having to pay tax on this gain. First, he can use the principal residence gain exclusion if he qualifies – used the home as his principal residence in at least two of the last 5 years. If Rob is married he can exclude 100% of the gain because the maximum exclusion is $500,000.
If Rob is unmarried he can only exclude up to $250,000 of gain. Rob can defer the gain not excluded by purchasing a replacement residence. Because this is a disaster loss, he has 4 years to build or buy replacement property.
Business vs Personal
The previously mentioned limits for personal casualty losses, ie. the $100/$500 per casualty/disaster limit and the 10% of AGI limit do not apply for business casualty losses, but the basic method of computing gain or loss is the same. Businesses must be mindful that the term “adjusted basis” refers to cost less any depreciation claimed in prior years.
Conclusion
The loss of so many homes and businesses in our community will have repercussions for many years. Home and business owners who were directly affected by this tragedy should be sure to speak with their tax advisors about their specific situation and how best to utilize tax rules to minimize or defer their taxable gain or maximize their deductible loss.