Disaster Losses. Phone: Fax: Your California solution since 1975

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1 Phone: Fax: Your California solution since 1975

2 This publication is distributed with the understanding that the authors and publisher are not engaged in rendering legal, accounting or other professional advice and assume no liability in connection with its use. Tax laws are constantly changing and are subject to differing interpretation. In addition, the facts and circumstances in your particular situation may not be the same as those presented here. Therefore, we urge you to do additional research and ensure that you are fully informed before using the information contained in this publication. Federal law prohibits unauthorized reproduction of the material in Spidell s Disaster Losses manual. All reproduction must be approved in writing by Spidell Publishing, Inc. This is not a free publication. Purchase of this electronic publication entitles the buyer to keep one copy on his/her computer and to print out one copy only. Printing out more than one copy and any electronic distribution of this publication is prohibited by international and United States copyright laws and treaties. Illegal distribution of this publication will subject the purchaser to penalties of up to $100,000 per copy distributed.

3 Table of Contents Addendum... A New developments... A Reporting casualty losses to business or income-producing property... C Introduction... 1 Types of tax relief available... 1 Federal versus California relief... 2 Extensions of time deadlines extended... 3 Affected taxpayers... 4 Disasters outside California... 4 Disaster losses... 5 What is the difference between a casualty and a disaster?... 5 Casualty loss limitations... 5 Personal property... 5 Business property... 5 Election to take disaster loss on prior-year return... 5 Due date for throwback disaster election... 6 Making separate elections for separate losses prohibited... 6 Separate elections... 6 Federal three-year NOL carryback period for disaster losses... 7 California conformity... 7 Interplay with net operating losses... 7 Revoking the election... 8 Calculating the gain or loss for individuals... 8 Appraisal is a must... 9 California conformity... 9 Where to deduct the cost of the appraisal... 9 Decline in general market value... 9 Kamanski v. Comm Finkbohner v. U.S Radding v. Comm Philmon v. U.S Clean-up and repairs Gain from foreclosure Calculating the gain or loss for businesses/income-producing property Leased property Loss of inventory Self-employment tax i Spidell Publishing, Inc.

4 Passive activities Insurance or other reimbursements Tax benefit rule Subsequent lawsuits Capitalize versus casualty loss IRC 121 gain exclusion Holding and use periods Involuntary conversions Replacement period Extensions Adjusted basis of involuntarily converted property Special rules for principal residences Interplay with IRC 121 exclusion Common pool of funds Deferring the gain Disaster relief and living expenses payments Qualified disaster relief payments California conformity Employer s emergency disaster fund Excess living expenses Other disaster relief Crowdfunding Other charitable donation issues Employer-sponsored leave donation programs California conformity Retirement plan distributions and loans Procedural and administrative relief Additional state tax relief for California wildfire victims EDD CDTFA Property taxes Transfers within same county Transfers to another county Damage test Additional hurricane relief Casualty losses Tax-favored withdrawals from IRAs and retirement plans Retirement plan loans Charitable contributions Employee retention credits Spidell Publishing, Inc. ii 2017

5 Earned Income Credit and Child Tax Credit Tips for times of disaster Tax planning tips Practice tips for handling disaster losses How to audit-proof your disaster/casualty loss Include the loss on the originally filed tax return Estimate and pay tax due with extension Basis reduction for land value Pictures will help Testimony Newspaper clippings Make an inventory File an insurance claim SBA paperwork Depreciate personal property iii Spidell Publishing, Inc.

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7 DISASTER LOSSES SPECIAL REPORT ADDENDUM NEW DEVELOPMENTS NEW EMERGENCIES In the first week of December, Governor Brown declared a state of emergency in the following counties: Los Angeles for the Creek and Rye Fires; San Diego for the Lilac Fire; Santa Barbara for the Thomas Fire; and Ventura for the Thomas Fire. At the time of publication, the President had not declared a Federal Disaster Declaration providing individual assistance to victims of these southern California wildfires. NEW LOSS CALCULATION SAFE HARBORS The IRS has released two new Revenue Procedures that provide for safe harbors for individuals to compute the amount of their casualty losses for personal-use residential real property and their personal belongings: Rev. Proc provides safe harbors for all taxpayers claiming a casualty or disaster loss; and Rev. Proc provides additional safe harbors for victims of Hurricanes Harvey, Irma, and Maria and is not addressed in this report. Casualty Loss Safe Harbors Safe harbor Type of loss Type of property Description/limitations Authorization Estimated repair cost safe harbor De minimis safe harbor Casualty loss Casualty loss Personal use residential real property Personal use residential real property May use lesser of two repair estimates prepared by two separate and independent licensed or registered contractors. Itemized costs must be provided. Costs limited to repairs to bring property to pre-casualty value (cannot include costs to bring property up to code). Limited to losses of $20,000 or less, prior to IRC 165(h) limitations. Limited to losses of $5,000 or less prior to IRC 165(h) limitations Good faith estimate of cost to bring property to pre-casualty condition. Taxpayer must maintain records detailing the methodology used. Rev. Proc Rev. Proc continued 2017 A Spidell Publishing, Inc.

8 Casualty Loss Safe Harbors (continued) Safe harbor Type of loss Type of property Description/limitations Authorization Insurance safe harbor Casualty loss Personal use residential real property May use the estimated loss determined in homeowner s or flood insurance reports. No income cap. Rev. Proc Contractor safe harbor Federally declared disaster loss Personal use residential real property Contract price for the itemized repair costs specified in a signed, binding contract between the taxpayer and a licensed or registered independent contractor to bring the property to its pre-disaster value. Rev. Proc (1) Disaster loan appraisal safe harbor Federally declared disaster loss Personal use residential real property Appraisal prepared to qualify for federal disaster loans or loan guarantees. Rev. Proc (2) De minimis safe harbor Casualty or theft loss Personal belongings Limited to losses of $5,000 or less, prior to IRC 165(h) limitations. Rev. Proc Good faith estimated of decrease in FMV. Recordings describing the personal belongings affected and detailing the methodology used for estimating the loss must be maintained. Replacement cost safe harbor Federally declared disaster losses Personal belongings Used to determine the property s predisaster FMV for purposes of calculating the casualty loss (see page 8 in report). The pre-disaster FMV is determined using the property s current replacement costs and reduce that amount by 10% for each year the property was owned by the taxpayer, with 10% minimum for property owned nine years or more. Rev. Proc If this safe harbor is used, it must be used for all qualified personal belongings for which a disaster loss was claimed. If a taxpayer elects to use one of the safe harbors, he/she must also take into account the value of any no-cost repairs (e.g., repairs covered by insurance or undertaken by volunteers or friends or family for a token amount). A taxpayer is not required to use one of these safe harbors. An individual may choose to use the actual reduction in the fair market value of the property under Treas. Regs (a)(2) as long as it is properly substantiated. Spidell Publishing, Inc. B 2017

9 Personal use residential property defined Personal-use residential real property is real property, including improvements such as buildings and ornamental trees, and shrubbery, that is owned by the individual who suffered the casualty loss and contains at least one personal resident. It does not include: A personal residence if any part of it was is used as rental property or contains a home office used in a trade or business or transaction entered into for profit; or Condominiums or cooperative units or similar property if the taxpayer does not own the structural components of the building (e.g., foundation, walls, and roof) or owns only a fractional interest in all of the structural units of the building, mobile home, or trailer. (Rev. Proc ) Practice Pointer The safe harbors are not limited to losses to primary residences. Therefore, taxpayers may use these for second homes and vacation homes, as long as they were not used as rental property. Personal belongings defined Qualified personal belongings are limited to tangible personal property owned by the taxpayer that is not used in a trade or business or in a transaction entered into for profit. (Rev. Proc ) The following are specifically excluded: Boats; Aircraft; Mobile homes; Trailers; Vehicles; and Antiques or other asset that maintains or increases its value over time. The availability of the new safe harbors outlined in Rev. Proc is dependent upon the cause of the casualty, the amount of loss, and the type of property as outlined in the table above. REPORTING CASUALTY LOSSES TO BUSINESS OR INCOME-PRODUCING PROPERTY Gains from income-producing property or gains/losses from a trade or business property or rental or royalty property are reported on Section B of Form 4684 and then transferred to Form 4797, Sales of Business Property. Deferred gains under IRC 1033 are reported by attaching a statement to the return, as described on page 19 of the report C Spidell Publishing, Inc.

10 Example of involuntary conversion of rental property In Year 1, Debbie and Marty purchased a duplex in Napa as rental property for the lump sum of $700,000. The purchase price was allocated between the land ($300,000) and the building ($400,000) for purposes of determining basis. In Year 3, the building was completely destroyed by the Tubbs Fire in Napa. At the time of the casualty, the adjusted basis of the land is $300,000, the adjusted basis of the building is $390,000. The fair market value of the land and building immediately before the casualty is $350,000 and $425,000, respectively, and immediately after the casualty is $350,000 and $0, respectively. In Year 3, insurance proceeds of $450,000 are received to cover the loss to the building. Because the property is used for trade or business purposes rather than personal purposes, the amount of the casualty loss must be determined by considering the separate fair market value and adjusted basis of each single, identifiable item of property damaged or destroyed. The amount of the casualty loss deduction is calculated as follows: Building: adjusted basis $390,000 Casualty loss before reimbursement ($390,000) Less: reimbursement - 450,000 Casualty gain on building $ 60,000 If Debbie and Marty decide to sell the Napa property and reinvest in another rental property in Lake County, they can defer reporting the casualty gain on their return. TREATMENT OF THE LAND Whether the sale of the land can qualify as part of the involuntary conversion when an investment/business property is destroyed is dependent on whether: The properties qualify as a one economic property unit; The unavailability of suitable nearby property of a like kind; and The proceeds of the voluntary sale must be used to acquire like-kind property. In PLR , a taxpayer had a three-unit rental on land located in a resort community. The taxpayer had purchased the property for $66,160 in 1972 and the property was destroyed by a gas explosion in In 1972, the land was worth $30,000 and in 1980 it sold for $165,000. The taxpayer only received $51,790 in insurance proceeds and due to the escalating cost of building in the area the taxpayer could not afford to rebuild in the area. The IRS ruled that the taxpayer could treat the destroyed building and the land as one economic property unit. The IRS also accepted the taxpayer s contentions that due to the escalating land and building costs in the area he could not afford to purchase a like-kind property in the area, and that similar property in another resort community in another state qualified as like-kind property. Therefore, the replacement property could be purchased with the tax deferred gain from the insurance proceeds and land sale. In PLR , the IRS held that an individual who owned a four-family apartment building that was destroyed by fire was able to treat the sale of the land as an involuntary conversion as well. Spidell Publishing, Inc. D 2017

11 The taxpayer showed that the rental building and the land constituted one economic unit of rental real estate and that rebuilding was not an economically feasible option. The taxpayer provided cost estimates for replacing the destroyed building with a similar structure and evidence that the current rental charges in the city in which the building was located would not economically support a building costing that much. In PLR , a taxpayer had a residential rental unit, which was a single-family dwelling that was destroyed by a tornado. The taxpayer had purchased the property decades earlier and therefore the property s adjusted basis was negligible. The taxpayer received insurance proceeds in one tax year and claimed an involuntary conversion for the gain from these proceeds. The taxpayer later determined that to rebuild on the land would be economically impractical because the area around the property was being developed into high-priced residential subdivisions and if he were to rebuild a property similar to what was destroyed it would be far out of character in terms of size, price, and quality of other residences in the area. The IRS agreed and found that the land and building constituted one economic unit, it was not feasible to find a replacement property in the area, and that the land could not practically have been used without replacement of the residential rental unit. Therefore, the taxpayer was allowed to treat the sale of the land in a subsequent year as a voluntary conversion. If the sale of the land qualifies as an involuntary conversion, gain from the sale proceeds qualify for deferral as long as it is sold within the allowed conversion period (two years generally, three years for certain property held for productive use in a trade or business or for investment; four years for principal residence destroyed in a disaster). (Rev. Rul ) 2017 E Spidell Publishing, Inc.

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13 INTRODUCTION Following the devastating 2017 wildfires in Northern and Southern California, California tax practitioners have renewed interest in the tax benefits available to affected taxpayers. The President declared Butte, Lake, Mendocino, Napa, Nevada, Sonoma, and Yuba counties as major disaster areas on October 8, Subsequent declarations included Orange County and, to a limited extent, Solano County. Practice Pointer There were numerous other fires and storms throughout California in However, while these events triggered state of emergency declarations by the Governor, they were not declared disaster areas by the President. Governor-declared states of emergency may qualify taxpayers to claim a California-only disaster throwback election (see page 6), but taxpayers impacted by these events do not qualify for full disaster-related tax relief available under the Internal Revenue Code. See the chart on page 2 for a comparison of relief available to victims of Presidentially declared disasters versus Governordeclared states of emergency. See page 3 for a full list of 2017 California disaster declarations. TYPES OF TAX RELIEF AVAILABLE The tax benefits available to affected taxpayers include: Extensions of time for filing income and franchise taxes (see page 3), as well as other property, payroll, and business taxes (see pages 3 and 27); Special disaster loss provisions of the casualty loss rules under IRC 165, which allow the taxpayer to report losses in the year prior to the disaster s occurrence (see page 5); IRC 121 primary residence gain exclusion for insurance reimbursements in excess of adjusted basis (see page 14); The involuntary conversion rules under IRC 1033, which allow the tax-free rollover of insurance reimbursements into similar property and exclusion of gain on reimbursements for destroyed primary residences and their contents (see page 15); and The exclusion from gross income of qualified disaster relief payments under IRC 139, and insurance proceeds for temporary living expenses under IRC 123 (see page 22). California conforms to IRC 123, 121, 139, 165, 1033, and 7508A. (R&TC 17131, , 17152, 18572, 24329) In addition, disaster loss carryback elections are available to impacted taxpayers in areas that the Governor has declared a state of emergency, even if the President has not declared the area a Presidential disaster. (R&TC , ) Hurricane relief Special federal legislation was enacted to provide expanded tax relief to victims of Hurricanes Harvey, Irma, and Maria. These expanded relief provisions do not apply to the wildfire victims, but we know many California preparers have clients who have moved to Florida or Texas, so we have provided a short summary of these provisions on page 31. Historically, Congress has not provided similar relief to wildfire disasters Spidell Publishing, Inc.

14 FEDERAL VERSUS CALIFORNIA RELIEF Federal and State Treatment of Disaster Losses Treatment available Declared by Governor only Declared by Governor and President Declared by President only California automatically conforms to federal filing deadline extensions No. However, reasonable cause may apply Yes Yes Does IRC 165(i) disaster loss throwback apply? Federal: No California: Yes Federal: Yes California: Yes Federal: Yes California: Yes Due date to file and claim IRC 165(i) disaster loss throwback election Federal: N/A California: Extended due date Federal: Six months from original due date California: Extended due date Federal: Six months from original due date California: Extended due date Three-year NOL carryback for individuals, small businesses, and farmers under IRC 172(b)(1)(E) Federal: Yes for individuals; No for businesses/farmers California: N/A (NOL carryback limited to two years) Federal: Yes California: N/A Federal: Yes California: N/A IRC 121 primary residence exclusion due to destruction Federal: Yes (disaster declaration not required) Federal: Yes California: Yes Federal: Yes California: Yes California: Yes IRC 1033(h) disasterrelated involuntary conversions Federal: No California: No Federal: Yes California: Yes Federal: Yes California: Yes IRC 139 disaster relief exclusion Federal: Yes* California: Yes* Federal: Yes California: Yes Federal: Yes California: Yes * Federal, state, or local government are excludable. Other payments may not be excludable unless it is a FEMA-declared disaster. See IRC 139(c) for details Spidell Publishing, Inc

15 State of emergency declaration date October 2017 October 2017 August 2017 and September California Losses that Qualify for Disaster Loss Treatment Type of disaster Cherokee, La Porte, Sulphur, Potter, Cascade, Lobo, and Canyon Fires Tubbs, Atlas*, and multiple other fires Railroad, Pier, Mission, and Peak Fires Declaration source President and Governor President and Governor Governor Counties/cities impacted Butte, Lake, Mendocino, Nevada, Orange Napa, Solano*, Sonoma, Yuba Madera, Mariposa, Tulare September 2017 La Tuna Fires Governor Los Angeles August 2017 Ponderosa Fires Governor Butte August 2017 Helena Fires Governor Trinity * Solano County is currently not included in the counties eligible to receive individual disaster assistance on FEMA s October 2017 map of California Wildfires (DR-4344) listing counties with a major disaster declaration. FEMA individual assistance disaster relief is required for taxpayers to receive many of the disaster relief provisions discussed above. As it appears right now, Solano County wildfire victims are not eligible for this relief EXTENSIONS OF TIME California generally conforms to federal law for postponement of certain tax-related deadlines due to a Presidentially declared disaster. All affected taxpayers including corporations, passthrough entities, trusts and estates affected by disasters receive the same tax relief provided under federal law DEADLINES EXTENDED The IRS and the FTB have given victims of the wildfires who are on a filing extension until January 31, 2018, to file their 2016 returns. (IR ; FTB News Release (October 13, 2017)) This applies to all taxpayers located in the disaster areas in the following counties: Butte, Lake, Mendocino, Napa, Nevada, Orange, Solano, Sonoma, and Yuba. Note: Both the IRS and FTB have included Solano County in their extension relief announcements. The January 31, 2018, extension relief applies to various tax filing and payment deadlines that occurred starting on October 8, 2017, including: Taxpayers whose tax-filing extension runs out on October 16, Because tax payments related to these 2016 returns were originally due on April 18, 2017, any payments associated with these filings are not eligible for this relief; FBARs with an extended due date of October 15, 2017 (FinCen Notice (October 19, 2017)); Quarterly estimated tax payments due January 16, 2018; Quarterly payroll and excise tax returns due on October 31, 2017; and Calendar-year tax-exempt organizations whose 2016 extensions run out on November 15, The IRS is also waiving late-deposit penalties for federal payroll and excise tax deposits normally due after October 8 and before October 23 if the deposits were made by October Spidell Publishing, Inc.

16 Affected taxpayers Extension relief applies to: Any individual whose main home is located in a covered disaster area; Any business whose principal place of business is located in a covered disaster area; Any relief worker affiliated with a recognized government or philanthropic organization and who is assisting in a covered disaster area; Any individual or business whose records are needed to meet a postponed deadline, provided those records are maintained in a covered disaster area. This would include: o o Taxpayers whose tax preparers are located in the disaster area; and All members of a combined reporting group if one of the members is an affected taxpayer included on a Schedule R-7, Apportionment and Allocation of Income (Note: The main home or principal place of business does not have to be located in the disaster area.); Any estate or trust that has tax records needed to meet a postponed tax deadline, provided those records are maintained in a covered disaster area; The spouse on a joint tax return with a taxpayer who is eligible for postponements; and Any other person determined by the IRS to be affected by a Presidentially declared disaster. Practice Pointer Taxpayers who have an address of record with the IRS in the disaster areas qualify for automatic relief. Other qualifying taxpayers seeking relief must contact the IRS at: Telephone (866) For California returns, call the FTB Tax Practitioner Hotline at: Telephone (916) DISASTERS OUTSIDE CALIFORNIA Federal disaster postponements automatically apply to taxpayers required to file a California return (resident or nonresident) as long as the taxpayer qualifies to claim a disaster loss. Taxpayers must write in red ink at the top of the return the name and date of the disaster for which the loss is claimed. This applies to victims of Hurricanes Harvey, Irma, and Maria as well. Affected taxpayers are granted a federal extension to file tax returns and make payments until January 31, 2018, and are also granted a similar extension if they have California-source income. For instance, if Hurricane Harvey impacted a taxpayer who earns income in California, that taxpayer has extra time to file a California tax return. This may include partners or S corporation shareholders of Florida or Texas businesses if they are unable to obtain the necessary records. Spidell Publishing, Inc

17 DISASTER LOSSES WHAT IS THE DIFFERENCE BETWEEN A CASUALTY AND A DISASTER? Special federal and California tax treatment is available to taxpayers who suffer a loss attributable to a disaster occurring in an area that the President declares a disaster under the Robert T. Stafford Disaster Relief and Emergency Assistance Act. (IRC 165(i)) A disaster loss is essentially just a souped-up casualty loss. If a casualty loss stems from a disaster, the taxpayer is given the option to elect to throw back the disaster loss to the preceding tax year so as to obtain a quicker refund. Personal property CASUALTY LOSS LIMITATIONS Individuals calculate their personal-use property losses on Section A of Form 4684, Casualties and Thefts, with the following limitations: $100 per-loss limit; and Subject to the 10% of AGI limit. Individuals may only claim a casualty loss deduction if they itemize their deductions. Practice Pointer The $100 per-loss limitation applies to each total casualty. It doesn t matter how many pieces of property are damaged in the event. Only a single $100 reduction applies. So if the a wildfire caused partial damage to the home, but the fire crews came in later and hosed down the house to prevent further fire damage, the loss would be considered to be part of one casualty. Married couples filing jointly are treated as one individual for purposes of the $100 limitation. If they file separately, they each must reduce their loss by $100, even if the property is owned jointly. Business property There are no limitations on business property losses, which are calculated on Section B of Form But note that an employee s unreimbursed business-use property losses are subject to the 2% AGI limitation. ELECTION TO TAKE DISASTER LOSS ON PRIOR-YEAR RETURN The entire loss, in the case of a Presidentially declared disaster may be taken on the prior-year s tax return. Taxpayers must claim all of the loss in the prior year or the current year. They cannot claim a portion of the loss in both the prior and current years Spidell Publishing, Inc.

18 Example of personal disaster loss John and Betty own a home valued at $825,000 with a basis of $750,000. The 2017 Northern California fire caused $100,000 worth of damage, which was not covered by insurance. In both 2016 and 2017, their California taxable income was $70,000 and their federal AGI was $75,000. Their allowable disaster loss is: Fire damage $100,000 Less 10% of federal AGI (7,500) Less $100 (100) Allowable disaster loss $ 92,400 They can elect to claim the loss on their 2016 or 2017 return, which will reduce their tax to below zero, thus getting a refund of any income taxes withheld or estimated taxes paid. Due date for throwback disaster election The term due date has a different meaning for federal purposes than for California purposes, although in reality in most cases the due date will now be the same. In 2016, the time to make a federal carryback election was revised. (T.D. 9789; Temp. Treas. Regs T; Prop. Treas. Regs ) The election must now be made within six months after the due date for filing the taxpayer s income tax return for the tax year of the disaster. Previously, taxpayers generally had until the original due date of the return for the disaster year to make the election. For California purposes, the due date is the due date for the return, including extensions. In the case of a loss in another state, the due date for the throwback election will be the federal election due date. Making separate elections for separate losses prohibited A throwback election under IRC 165(i) applies to all losses related to a disaster. (Treas. Regs T(c)) Even if a taxpayer sustained losses to multiple properties, he or she cannot throw back the loss from one property to the preceding year and claim the loss from another property in the current year. Separate elections A separate election may be made for California and federal purposes. Thus, a taxpayer may claim the loss from the 2017 Northern California fires on the 2016 return for California purposes and on the 2017 return for federal purposes, or vice versa. A taxpayer may want to make a separate California election for any number of reasons, including: The taxpayer had a federal NOL carried into 2017 but no California NOL; or Due to nonconformity to federal IRC 179 and bonus depreciation, the taxpayer may want to claim the loss on the 2017 California return, while making the throwback election on the federal return. California-only throwback election California also allows taxpayers to make a carryback election on the California return for losses stemming from disasters for which the Governor has declared a state of emergency, even if the President has not issued a disaster declaration for the area. (R&TC , ) This means that the taxpayer could make a carryback election on the California return, even though it isn t permitted on the federal return. Spidell Publishing, Inc

19 Federal three-year NOL carryback period for disaster losses Federal, but not California law, allows a three-year carryback for eligible losses. (IRC 172(b)(1)(E)) An eligible loss is defined as: In the case of an individual, losses of property arising from fire, storm, shipwreck, or other casualty, or from theft (Note: A disaster declaration does not have to be claimed for an individual to make a three-year carryback election on a federal return); In the case of a small business, NOLs attributable to federally declared disasters; and In the case of a farmers, NOLs attributable to such federally declared disasters, not including a farming loss under IRC 172(h) eligible for a five-year carryback. A qualified small business is a business that has average annual gross receipts (reduced by returns and allowances) of $5 million or less during the three-year period ending with the tax year of the NOL. If the business did not exist for this entire three-year period, use the period the business was in existence. California conformity California s carryback is two years. California does not have an extended three-year carryback for disaster losses. Interplay with net operating losses A big benefit of disaster loss treatment is that for any loss declared by either the President or the Governor, a taxpayer may be able to obtain five years (four years for California purposes) of immediate tax benefit: the current year, throwback to the immediate prior year for the disaster loss and, if an NOL is created or increased, an additional three years (two years for California) of carryback attributable to the NOL. Plus, remaining losses can also be carried forward. Example of disaster loss/nol interplay Joe s business in Sonoma County was destroyed in the 2017 fires for which a Presidential disaster was declared. His business was not insured, and his loss was $300,000. Under IRC 165(i), he may claim the loss on either his 2017 or 2016 return. Joe s income is approximately $60,000 per year, and the unused loss will create an NOL. If he elects to claim the loss on his 2016 return, he can carry back the unused loss to 2013, 2014, and 2015 for federal purposes, and 2014 and 2015 for California purposes. If there is a loss remaining, he may carry the loss forward to the 2017 year. This provides him five years of refunds now (four years for California). If he does not make the throwback election, he will claim the loss on the 2017 return and may carry 100% of the NOL back to 2014 (federal only), 2015, and But he won t be able to claim the disaster loss until he files the 2017 return in In any event, he may carry any unused loss forward for 20 years from the year the loss is claimed Spidell Publishing, Inc.

20 Revoking the election A taxpayer may revoke an election on or before 90 days after the due date for making the election. (Treas. Regs T(g)) Because California conforms to federal law, this also holds true for California purposes, although as noted above, the due date may be different for California purposes, and a taxpayer may elect to revoke on the federal return but not the California return, or vice versa. CALCULATING THE GAIN OR LOSS FOR INDIVIDUALS A casualty loss is calculated by subtracting insurance or other reimbursement received or expected from the lesser of the following amounts: The decrease in fair market value of the property as a result of the casualty; or The adjusted basis of the property before the event. Example of loss from casualty Quincy s principal residence was destroyed in the Napa fire. His basis in the home was $300,000. Fair market value prior to the fire was $600,000. Fair market value after the fire was $250,000. Quincy was uninsured. His loss is $300,000 (the decrease in fair market value was limited to Quincy s basis in the property). Quincy will recognize a loss of $300,000. If he subsequently sells the land, the entire amount would be taxable since the basis in the property is reduced by the loss recognized. The taxpayer will realize gain if the insurance or other reimbursements exceed the basis. However, as discussed on page 15, under IRC 1033, the taxpayer may purchase replacement property and defer any gain realized on the casualty loss. If the gain is due to the destruction of a primary residence, the IRC 121 exclusion may apply (see page 14). Example of gain from casualty Lil O Ladee owned a vacation home in Santa Rosa. The home had a value of $750,000 prior to the fire. The basis in the house was $250,000. Insurance reimbursed Lil $575,000, which she used to rebuild a smaller home on the same lot. The cost of the home she built was $500,000. Her gain on the casualty was $75,000. Caution Replacement cost is not a factor in computing the amount of loss that may be claimed. So even though it might cost a taxpayer $1,000 to replace their bedroom furniture, if the furniture s value was $250 prior to the fire, their loss is limited to $250. If their insurance reimburses them for their replacement cost, they would have to include the $750 in gross income. However, if the home was their principal residence, they may be able to exclude the gain from the reimbursement (see page 14). If the furniture was in a vacation home, the entire gain must be reported. Spidell Publishing, Inc

21 APPRAISAL IS A MUST To determine the decline in fair market value for real property, the taxpayer must have an appraisal of the property immediately after the casualty occurs or as soon as possible. Practice Pointer For federal and California purposes, an appraisal for the purpose of obtaining a loan of federal funds or a loan guarantee from the federal government as a result of a Presidentially declared disaster (as defined by IRC 1033(h)(3)) may be used to establish the amount of any loss to the extent provided in regulations or other guidance of the Secretary of the Treasury under IRC 165(i)(4). (R&TC , ) The appraisal is critical because, if the IRS or the FTB is going to audit the loss, the audit probably will not occur until two or three years after the loss occurred. The appraisal must be done by a qualified appraiser. The IRS issued guidelines for appraisal formats in Revenue Procedure If the taxpayer uses an invalid appraisal, the IRS may assess the following penalties for overstatement of loss: Substantially understating the taxpayer s federal income tax (exceeding the greater of 10% of the tax due or $5,000) will result in a 20% penalty on the underpayment (IRC 6662); or A 20% penalty will be assessed if the value of property claimed is more than 200% of the correct value. (IRC 6662(b)(3) and (e)(1)) California conformity California has comparable penalties. (R&TC 19164) Where to deduct the cost of the appraisal For individuals, deduct the cost of the appraisal on Schedule A as a miscellaneous itemized deduction subject to the 2% of adjusted gross income limitation. Do not deduct the appraisal as part of the casualty loss. (IRC 67, 165; IRS Publication 529) DECLINE IN GENERAL MARKET VALUE The general decline in market value is excluded from the calculation of the loss. (Treas. Regs ) For example, after the Northridge earthquake, the general value of the area declined because of people s fear of future earthquakes. This general decline in market value is not part of the casualty. Only the actual decline in the value of the property itself is allowable as a loss. However, as can be seen below, courts and the Board have distinguished between loss of value due to temporary buyer resistance (loss disallowed) verses a permanent impairment of value (loss allowed). Temporary buyer resistance is the loss of present value of property generated by a fear of future casualty damage that has a detrimental effect only while the natural disaster is fresh in people s minds. On the other hand, when a natural disaster has effects that cause changes that will outlast the fresh recollection of [the] disaster, a permanent injury to value has occurred. The Board rejected the FTB s argument that Finkbohner (discussed below) was wrongly decided, and relied on a permanent impairment theory in deciding that a taxpayer could claim a loss for the Spidell Publishing, Inc.

22 reduction in his property s overall value when a portion of his property fell into the ocean after a severe storm. (Appeal of Dighera (February 26, 2015) Cal. St. Bd. of Equal., Case No ) The FTB conceded that the taxpayer was entitled to $55,000 in damages resulting for the portion of the property that fell into the ocean, but disallowed the portion of the loss claimed for the remaining portion of the property (over $1 million). The Board found that due to the loss of footage on the property, the remaining land shrunk to such an extent that it no longer allowed for adequate setbacks if the buildings ever needed to be replaced, therefore dramatically reducing the value of the property to future sellers. Kamanski v. Comm. The taxpayer suffered cracks in the Palos Verdes mudslides. (Kamanski v. Comm. (1970) 29 TC 1702) The actual cost to repair the damage was around $1,500. However, the taxpayer who had been trying to sell the property, and subsequently gave it back to the bank was not entitled to deduct the decrease in value. The casualty loss was limited to the repair costs. Finkbohner v. U.S. The Eleventh Circuit Court of Appeal allowed the entire reduction in fair market value to this taxpayer. (Finkbohner v. U.S. (1986) 788 F.2d 723) In this case, as a result of the casualty, four other homes on the cul-de-sac were demolished because of the danger of future flooding. This decreased safety and changed the look of the neighborhood, so the entire reduction in fair market value was allowed. Radding v. Comm. The taxpayer tried to use the Finkbohner case in order to deduct the reduction of fair market value due to decline in the area. (Radding v. Comm. (1988) 55 TCM 1029) The court, as in Kamanski, sided with the IRS and said that if there was a future landslide, the taxpayer would take the casualty loss then. Philmon v. U.S. The taxpayer argued that a series of freezes that destroyed their citrus crops over the course of several years caused the value of their property to be permanently damaged because buyers had a resistance to buying freeze-prone grove land. (Philmon v. U.S. (1999) U.S. District Court, Middle Dist. of Florida, Case No CV-T-24(A)) But the court found that any loss in value was due to temporary buyer resistance and not a permanent change in value. CLEAN-UP AND REPAIRS Clean-up expenses may be used as a measure of loss if all the following conditions are met: The repairs are necessary to bring the property back to its condition before the casualty; The amount spent for repairs is not excessive; The repairs take care of the damage only; and The value of the property after the repairs is not, due to the repairs, more than the value of the property before the casualty. (Treas. Regs (a)(2)(ii)) The cost of repairs is not necessarily the decline in fair market value. However, in some cases, the courts have allowed repair costs as the amount of the loss. (Harmon v. Comm. (1949) 13 TC 373; Ford v. Comm. (1974) 33 TC 496) The taxpayer s deduction of loss was measured by the difference between the cost of repairs and the insurance reimbursement received. The evidence indicated that the repairs did not fix all the damage, the amount paid was not excessive, and the value of the Spidell Publishing, Inc

23 property was not increased by the repairs. The taxpayer testified as to the value of the property before the casualty but had no evidence of the value afterwards. The court accepted the cost of repairs as an indication of the amount of the loss. GAIN FROM FORECLOSURE Some taxpayers who suffer major losses in disasters are uninsured. These people are often faced with a tax aftershock. That is, they have property that is worth significantly less than the mortgage on the property. With large repair bills and no insurance to help defray the cost, these taxpayers often choose to walk away from their property and let the lending institution foreclose. These taxpayers could now have a taxable event on the foreclosure, which could turn out to be a gain (IRC 108), although the gain may qualify for the insolvency exclusion. Example of gain on foreclosure Joe owned a rental property in Northridge, California, which had a basis of $100,000 and a mortgage of $150,000. The fair market value prior to the 1994 earthquake was $250,000. The fair market value after the earthquake was $50,000. The reduction of fair market value of the building was $125,000, and the reduction in value due to decline in the area was $75,000. Joe had no earthquake insurance, and he decided he had no choice but to walk away from the property. Joe had a gain on the foreclosure of $50,000 ($150,000 - $100,000). This gain was in the form of debt relief. Joe was be able to exclude the COD income under the insolvency COD exclusion on his federal and California returns. CALCULATING THE GAIN OR LOSS FOR BUSINESSES/INCOME- PRODUCING PROPERTY The decrease in FMV is not considered in determining the amount of the disaster loss on business or income-producing property, such as rental property. The loss is determined by subtracting the salvage value of the property, plus any insurance or expected reimbursement, from the property s adjusted basis. LEASED PROPERTY Lessees may claim a loss on property they lease equal to the repair costs less any insurance or other expected reimbursements Spidell Publishing, Inc.

24 LOSS OF INVENTORY Losses on inventory may be claimed either as a casualty loss or as part of the cost of goods sold: If deducting the loss through the increase in the cost of goods sold by properly reporting your opening and closing inventories, a disaster/casualty loss is not claimed, and no throwback election may be made. Any insurance or other reimbursement received in the loss must be included in gross income; or If deducting the loss as a disaster loss, a downward adjustment must be made to opening inventory or purchases for the year the loss is claimed. Any reimbursement received reduces the amount of loss claimed and is not included in gross income. If a taxpayer does not receive the reimbursement by the end of the year, a loss cannot be claimed to the extent there is a reasonable prospect of recovery. Self-employment tax A loss taken in a prior year will reduce self-employment income if the loss is a self-employment loss. (Rev. Rul , CB 265) Practice Pointer As discussed above, losses of business inventory can be treated as either a casualty loss or as part of cost of goods sold. Treating this kind of loss as part of COGS will generally mean that taxpayers will have less net income from their business, which, depending on their income level, may reduce their self-employment tax. Passive activities Casualty losses are treated as nonpassive activities under Treas. Regs T(d)(2)(xi). If a taxpayer suffers a casualty loss on a rental property, he or she may take a loss without regard to passive activity limitations. A taxpayer suffered a loss of $44,000 due to fire damage to her rental property and claimed the loss as a casualty loss. (Agosto, TCS ) The IRS attempted to limit the loss to the $25,000 active participation limit. However, the court, citing Treas. Regs (d)(2)(xi), stated that even if an activity is passive, casualty losses are permitted if the requirements of IRC 165 are met. Note that, on the flip side, any gain resulting from insurance proceeds won t be passive income. INSURANCE OR OTHER REIMBURSEMENTS Insurance and other reimbursements must be subtracted from the property s adjusted basis or decrease in FMV in determining the amount of loss that may be claimed. A taxpayer that has insurance must submit a claim in order to claim a loss unless the amount of loss is less than the deductible amount. Other reimbursements that may reduce a taxpayer s loss include: Employer s emergency disaster funds (but only if these funds must be used to rehabilitate or replace property; if they can be used in any manner the employee chooses, they will not reduce the loss); and Disaster benefits if they must be used for property repair/replacement. Spidell Publishing, Inc

25 Items that will not reduce the amount of your casualty loss include: Cash gifts from relatives or crowdfunding sources even if used to restore/replace property; and Insurance payments for living expenses (see page 20 for more on this topic). TAX BENEFIT RULE If you elect to carry the loss back and underestimate the amount of the insurance reimbursement, the insurance proceeds received that are in excess of the amount claimed on the return must be included in income in the year received. (IRC 111; Rev. Rul ; Londagin v. Comm. (1973) 61 TC 117) Example of underestimated insurance reimbursement Daniel Jack s home in Napa was destroyed by the California wildfires. His insurance adjuster told him that his reimbursement would be $100,000. Daniel s loss after the reimbursement was $50,000. Daniel elected to take the casualty loss on his amended 2016 tax return, which he filed on April 15, In late 2018, the insurance company sent him reimbursement of $125,000. This additional $25,000 must be included in Daniel s adjusted gross income for the year 2018 under the tax benefit rule. Example of overestimated insurance reimbursement Jim Beeme also suffered damage in the California wildfires. He also elected to amend the 2016 tax returns and include the loss on those returns. He estimated that his insurance reimbursements would be $100,000. He included this $100,000 in calculating the loss. However, Jim had failed to pay the premium on his insurance policy, and the insurance company would not pay his claim. Jim was notified in September 2018 that he would receive no reimbursement. He should file another amended 2016 tax return and increase the amount of the loss. Subsequent lawsuits A taxpayer who sues a city, landlord, insurance company, etc., should report any proceeds in the same manner as an insurance reimbursement. The proceeds would be taxable in the year received unless reinvested under IRC However, if the taxpayer had previously taken a loss and subsequently receives an insurance reimbursement or settlement, the amount must be included in income under the tax benefit rule. (Treas. Regs (d)(2)(i)) If a taxpayer is sued as a result of a disaster loss, the taxpayer would recognize the loss or take the deduction in the year that the suit was settled. Treas. Regs (d)(2) states that [A] loss shall be treated as sustained during the taxable year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year Spidell Publishing, Inc.

26 CAPITALIZE VERSUS CASUALTY LOSS Can a taxpayer continue to depreciate the old property and capitalize the repairs and replacements in lieu of taking a casualty loss? Under the regulations for IRC 167, a loss is recognized when an asset is retired by actual physical abandonment, such as condemnation. (Treas. Regs (a)-8) Thus, if a taxpayer suffers damage in a disaster, the loss should be calculated and no further depreciation for that property may be taken. Any reconstruction or repairs should be expensed or capitalized, as appropriate under the IRC. However, the maximum loss allowed is the adjusted basis of the asset. If only a portion of the property was destroyed in the disaster, the MACRS partial asset disposition regulation, Treas. Regs (i)-8(d), adopted as part of the tangible property repair regulations, requires the taxpayer to treat the casualty as a disposition. It is not optional as is the case when a taxpayer disposes of part of an asset voluntarily. A taxpayer must calculate a gain or loss from the disposition so they will need to know their basis in the asset. In the case of a restoration (not a betterment or adaptation) of a portion of a unit of property, when it is impractical to determine the adjusted depreciable basis of an asset from a taxpayer s records, then any reasonable method may be used to make the determination. Once a method is chosen, it must be consistently applied to all portions of the asset disposition. (Treas. Regs (i)-8(f)(3)) So if a hurricane ripped off a roof and a wall from a building, the taxpayer would be required to use the same method of determining basis for both the roof and the wall. Restorations after a casualty require certain amounts to be capitalized, but there is a formula that limits the amount required to be capitalized. In general terms, the amount required to be capitalized is the excess of the adjusted basis of the property over any amount paid to restore the property. Costs in excess of that amount may be eligible to be treated as an expense. (Treas. Regs (a)- 3(k)(4)) There are a couple of good examples of capitalization of restoration costs after a casualty in the regulations (see Treas. Regs (a)-3(k)(7) examples 3, 4 and 5). Example 5 is a great example of the limitation on the amount that needs to be capitalized and the amount that can possibly be treated as a repair expense. IRC 121 GAIN EXCLUSION As can be seen above, because taxpayers may receive more in insurance and emergency grants than the adjusted basis of the property, taxpayers might find that they are realizing a tax gain from their disaster-related reimbursements. However, homeowners may be able to exclude this gain through their IRC 121 primary residence gain exclusion. Destruction or condemnation of a property qualifies as a sale for purposes of the IRC 121 exclusion. (Note: The destruction does not have to be due to a Presidentially declared disaster.) (IRC 121(d)) So taxpayers that meet the ownership/occupancy requirements for two out of the last five years will qualify for the $250,000 exclusion ($500,000 for married taxpayers). Because a natural disaster is considered an unforeseen circumstance, taxpayers who do not meet the two-year owner/occupancy requirements may still qualify for a prorated exclusion. (IRC 121(d)) Spidell Publishing, Inc