REPAIRS ALLOWABLE, CASUALTY LOSS DEDUCTION

REPAIRS ALLOWABLE, CASUALTY LOSS DEDUCTION

(A question asked recently of this blog)

This is the last of 8 questions that I reported to you on May 21, 2013.

This is a multi-part question. Here are the components that will be addressed in this post:

Repairs Allowed

Casualty Loss Deduction

Because the inquiry puts together repairs allowed with the casualty loss deduction, the inquirer has made a juxtaposition of concepts that need to be deciphered and analyzed in context of each other. There are two additional items that I will deal with that are also related to the same issues:

         Debris removal

         Difference between using the “Cost or Repairs” and “Appraisal” methods of claiming a loss

This combined question is a very rich inquiry. It brings up very important issues, ones that are not directly asked in the question. But this question allows me to cover the bigger concerns. Additionally, the question is an example of how taxpayer’s questions must be viewed through the filter of a person who has experienced a catastrophic event and in their post-event situation, not only are they expected to be thinking clearly, but now they are also faced with dealing with the Internal Revenue Code. In their present state of mind dealing with the Code would be difficult, but now there are Code sections they have not had to think about before, that is going to be even more difficult. These people who have been “Disastered” will go to their tax professional to get help with these new tax issues only to find that the tax professional does not have the in-depth knowledge to give answers to important questions such as this one.

The big concern that relates to the question involves the use of the Appraisal valuation method vs. the Cost of Repairs method.

Before getting into the specific issues, there is a bit of business that needs to be addressed. This question only applies to Casualty Loss Deduction situations; it does not apply to Involuntary Conversions. You will see why below. What is the difference between a Casualty Loss Deduction situations and an Involuntary Conversions? Specifically, that question is discussed in other material on this blog. But I will give a short answer:

An Involuntary Conversions occurs when the insurance proceeds from a catastrophic loss situation exceed the “cost basis” of the property damaged or destroyed. A Casualty Loss Deduction arises when the insurance proceeds are inadequate or no insurance coverage exists in the situation. I will discuss the situation from both the loss and the involuntary conversion situation.

Here is the overall problem.

The difficulty in responding to the question of “REPAIRS ALLOWABLE, CASUALTY LOSS DEDUCTION” is the answer depends on what is the bacis of the taxpayer’s situation. The three possibilities are that the taxpayer is in an involuntary conversion situation, that is, the insurance proceeds are greater than the cost basis of the property damaged or lost. If that is not true then there is most likely a casualty loss. (Although it is possible that there is neither a casualty loss nor a reportable involuntary conversion in some cases.) For a casualty loss situation the critical question is whether the claim for the loss is based on the “Cost of Repairs” or “Appraisal” method of determining the loss. These two methods are discussed in numerous entries on this blog. I have tried to dissuade taxpayers from using the “Cost of Repairs” method in most large losses. But it is in the Code and is often the choice of inexperienced tax professionals. Therefore, it must be a part of the discussion. The three main situations will be separately discussed as responses to each of the areas of the inquiry.

There should be no expectation that the computed loss using the two methods: “Cost of Repairs” or “Appraisal” method will arrive at the same result. In fact, it is not likely that the two methods will result in the same loss amount. Additionally, it is likely that the difference will be large.

If the taxpayer is in an Involuntary Conversion situation, yes they may have insurance proceeds greater than the cost basis of the property, but that does not automatically mean that there is sufficient money available to restore the property to its pre-loss condition. The property may have been purchase decades ago, the replacement costs could have escalated dramatically since the purchase. New building codes enacted since the purchase may impact the repair / restoration costs. Conditions of the disaster may impose new costly restrictions and requirements on the restoration process.

REPAIRS ALLOWED

To state the obvious, repairs are how taxpayers try to return their lives and property to a pre-loss condition.

Involuntary Conversion

When a disaster results in an Involuntary Conversion the issue is whether the replacement meets the specific rules of Internal Revenue Code Section 1033 regarding replacements and repairs. The Code specifies that there is a gain resulting from the fact that the insurance proceeds exceed the cost basis of the property lost or damaged. In order to defer the gain the taxpayer must follow the rules of Section 1033 of the Code.

The basic rule is that the repairs / replacement must be “similar or related in service or use to the property lost.”

·         For personal use real estate, any personal use real estate is acceptable.

·         In a disaster situation, the personal loss replacement costs can include certain personal property (contents).

·         Generally, for business and investment losses the rule is a bit tighter; a grocer cannot replace the supermarket lost with a theater; however an investor who rented a building to a grocer can replace the property with a theater that is rented to a theater operator. (But as an invest, he/she cannot operate the theater).

·         For the business or investor, in a disaster situation the replacement can simply meet the standard of it being “of a type held for productive use in a trade or business.”

Therefore, if the grocer replaces the 100 square foot refrigerator with a 200 square foot refrigerator it will likely be “similar or related in service or use.” However, adding an auto repair shop to the grocery store, while an increase in the cost basis of the property, would not likely qualify as “similar or related in service or use” for purpose of an involuntary conversion replacement . But if the loss was part of a federally declared disaster, the auto repair shop would likely qualify as “of a type held for productive use in a trade or business.”

In a disaster, the investor could replace the building rented to a business operator with an actual operating business. If the investor wanted to replace the building rented to a business operator with another building rented to a business operator, that would be ok, it would fall under the general replacement rules not the disaster rules.

For the personal use real estate, including a primary residence or a vacation home, adding a bedroom or acquiring an additional personal use residence would qualify. In a federally declared disaster purchase of couches, televisions, works of art, antiques, etc. would likely qualify. (In a disaster, the taxpayer need not worry about any “gain” related to insured contents lost.)

In situations such as Hurricane Katrina or the more recent Hurricane Sandy Super Storm, the local building codes have been modified to require substantial elevation of many structures that are subject to possible future storm surge flooding. These modifications, requiring substantial financial burdens of raising an existing building, would be part of the costs that would be included in those meeting the qualifying definitions listed as part of the repairs in an involuntary conversion, in my opinion.

Generally, dealing with an involuntary conversion replacement is fairly broadly defined.

Casualty Loss Deduction – Using the “Cost of Repairs” Method to compute the Loss

If a Casualty loss deduction has been claimed using the “Cost of Repairs” method to compute the loss there are very specific rules that must be complied with in the repair process for the cost to qualify in the loss computation. It is because of these rules that I strongly recommend that the “Cost of Repairs” method not be used to compute a casualty loss.

1.   The repairs (only repairs) are required to be completed in order to claim the loss. This might be difficult to comply with if the loss occurs near the end of the year and the taxpayer wants to deduct the loss on the return for the actual year of the loss. Granted, the tax return can be filed as late as October of the following year. But the municipal building department approval process may be very lengthy.

 2.  Only those costs necessary to return the property to its “pre-loss condition” are permitted to be included in the costs incurred to determine the loss. No betterments are allowed. Taxpayers always upgrade when repairing their property.

3.   Other costs incurred in the repair process would simply be additions to the post-loss cost basis of the property.

Casualty Loss Deduction – Using the “Appraisal” Method to compute the Loss

Using the “Appraisal” method to complete the loss separates the repairs from the loss computation. The  use of the “Appraisal” method requires an appraisal prepared by a qualified appraiser. Once the loss is computed the taxpayer is done with that part of the recovery process. The basis of the damaged property has been decreased by the damages claimed in the loss calculation along with the cost reduction associated with any insurance proceeds.

The taxpayer is free to repair the property in whatever way determined to be appropriate or even replace the property altogether. The repairs increase the cost basis of the property as they as incurred.

CASUALTY LOSS DEDUCTION

Involuntary Conversion

In an involuntary conversion there is not a “CASUALTY LOSS DEDUCTION.”

Casualty Loss Deduction – Using the “Cost of Repairs” Method to compute the Loss

As alluded to above, using the “Cost of Repairs” method to compute the Form 4684 casualty loss requires that the cost first be expended to actually repair the damaged property, thereby actually computing the “Cost of Repairs” as a result of incurring the costs. Only those costs actually necessary to bring the property to its pre-loss condition are allowed in the computation.

Betterments are not “Cost of Repairs.” In one case the taxpayer “repaired” the basement foundation by adding pilasters to reinforce the old basement walls.

The Tax Court in LUTZ, (35 TCM 661) determined that:

“The additional [sic] of pilasters to the basement walls as part of the post-flood repair work was an improvement to the property.”

In the LUTZ case the taxpayer was denied the cost of the pilasters as part of the “cost of repairs” computation of the loss. They were part of the taxpayer’s computation of the post-event cost basis. The pilasters would not have entered into an appraisal loss computation.

Casualty Loss Deduction – Using the “Appraisal” Method to compute the Loss

As explained above, using the “Appraisal” method separates the casualty loss deduction from the repairs process. The deduction is claimed based on the four basic amounts: Cost basis, Insurance, Appraisal (pre-loss and post-loss).

DEBRIS REMOVAL

After any catastrophic loss there is a mess to clean up. The rubble is usually called debris. The debris is the result of the event, but the clean-up is not part of any casualty loss according to the IRS. The clean-up is considered part of the repairs.

DIFFERENCE BETWEEN USING THE “COST OR REPAIRS” AND “APPRAISAL” METHODS OF CLAIMING A LOSS

For some difficult situations that I will not go into at this time, taxpayers and their tax professionals are directed to look up a very interesting but limited case: ABRAMS TCM 1981-231 (1972 3.1Mv Earthquake).

This blog, “AccountantForDisasterRecovery.com” has been addressing taxpayer income tax issues related to catastrophic losses for more than five years.

All rights to reproduce or quote any part of the chapter in any other publication are reserved by the author. Republication rights limited by the publisher of the book in which this chapter appears also apply.

	JOHN TRAPANI
	Certified Public Accountant
	2975 E. Hillcrest Drive #403
	Thousand Oaks, CA 91362
	(805) 497-4411
	Contact us through our website at:
	www.trapanicpa.com/contact/
	Blog: www.AccountantForDisasteRrecovery.com
	It All Adds Up For You

This material was contributed by John Trapani. A Certified Public Accountant who has assisted taxpayers since 1976, in analyzing and reporting transactions of the type covered in this material.  

Internal Revenue Service Circular 230 Disclosure

This is a general discussion of tax law. The application of the law to specific facts may involve aspects that are not identical to the situations presented in this material. Relying on this material does not qualify as tax advice for purpose of mounting a defense of a tax position with the taxing authorities

The analysis of the tax consequences of any event is based on tax laws in effect at the time of the event.

This material was completed on the date of the posting

© 2013, John Trapani, CPA,

HOW TO REPORT MULTIPLE ITEMS AS A CASUALTY LOSS

HOW TO REPORT MULTIPLE ITEMS AS A CASUALTY LOSS

(A question asked recently of this blog)

Reporting a loss on multiple items lost in one event presents thorny issues to resolve. On one hand, there are some obvious ways to group items. Generally, we would start with insurance policy coverage categories. Using this one, for a personal loss involving a home, contents, vehicles, and boats, etc. that would be covered by separate insurance limits (regardless of whether they were actually covered by insurance) and many covered by separate policies, especially  vehicles and boats, etc. But what about the contents?

For personal use real estate, the IRS tells us that we do not allocate between land and structures and other improvements such as landscaping. The insurance policy will generally have a category for structure and one for appurtenant structures; these would be combined for real estate. Additionally, if there is additional coverage for specific improvements and features such as trees, this would also be combined with the rest of the structure and appurtenant structures coverage. Each vehicle would be listed individually as would boats and RV’s. That leaves contents. Here is where it gets interesting.

CONTENTS / PERSONAL PROPERTY LOSSES

Since the OWENS case established the rule for personal asset adjusted cost basis, the “Separate computations” rule creates additional computational restrictions for assets such as contents of a home. For each item lost it is necessary to compute the original cost basis, value before the event and the value after the event, item by item. The following table is an example of how this can be done. In the table below, by computing the loss item-by-item the loss is less than either of the two aggregate methods computed above.

Line	Descrip-										Loss
	Tion of			Value	Value		Condition		Limits		Before
	Item Damaged			Before	After		Afater		Of		Insurance
	or Destroyed		Cost	Event	Event		Event		Loss		Proceeds
1	Couch		2,500	1,600	1,400		Needs cleaning		Pre-event Value		200
2	Table		500	300	100		Scratched				200
3	Chair		375	275	0		Destroyed				275
4	Antique mirror		1,500	4,000	0		Destroyed		Cost		1,500
	1 - 4 Sub-total		4,875	6,175	1,500						2,175
5	Necklace		1,200	1,200	0		Destroyed		Cost		1,200
6	4 Men’s suits		2,800	600	0		Destroye		Pre-event Value		600
	5 and 6 Sub-total		4,000	1,800	0						1,800
	Total		8,875	7,975	1,500		Total Computed Loss:				3,975
	Gross Cost less post- event values				7,375
	Gross pre-event less post-event values				8,875

CONTENTS / PERSONAL PROPERTY GAINS

A gain is realized if the insurance proceeds received exceed the cost basis immediately before the event, without reduction for pre-event fair market value adjustments. Additional issues involve whether proceeds are received for property damage or other coverages or are covered by other Code sections such as grants and additional living expenses.

The insurance claim for the loss is processed, the tables below presents the results of an insurance claim and the gain / -loss realized as well as the affect of a partial reinvestment of proceeds. There is an item that is limited in coverage (* necklace) and in this example, the insurance company arbitrarily pays only 80% on the balance, claiming other sources could be accessed to acquire replacements. The taxpayers make purchases to reacquire some items, but they decided to do without the antique, the necklace and suits. Overall, the taxpayer has reinvested $7,200 of the $11,080 insurance proceeds. The net gain not reinvested is as computed on an item by item basis equal to $1,580, but the total proceeds not reinvested in similar items is $3,880 ($11,080 proceeds less $7,200 reinvested). The taxpayer has a net gain of $1,580.

Line		Replace-	Insurance	Insurance			Acquisition	Gain Not		Loss
		Ment	Limits	Proceeds		Gain	of Replace-	Rein-		Real-
		cost	Applied	80% *		-Loss	ments	vested		ized
1		3,700	3,700	2,960		460	5,700
2		700	700	560		60	700
3		600	600	480		105	800
4		4,000	4,000	3,200		1,700		1700
1 - 4 Sub-total		9,000	9,000	7,200		2,325	7,200
5		3,000	1,000	1,000	*	-200	0			-200
6		3,600	3,600	2,880		80	0	80
5 & 6 Sub-total		6,600	4,600	3,880		-120	0
		15,600	13,600	11,080		2,205	7,200	1,780		-200
	*	Maximum limit of coverage for jewelry							Net Gain
									$1,580

While there is a net gain of $1,580 applicable to the last three items not reinvested, that is not necessarily the gain that is reportable by the taxpayer. If the antique mirror that was not replaced is judged to be similar or related in service or use as the couch, table an chair, the taxpayer has reinvested the funds sufficient to avoid reporting any gain, deferring gain on items 1-4 of $2,325.

While these details may not be material in a small case, when the quantity and quality are great, the need to attend to the details will be important, the choices and analysis and resulting decisions could have significant impact on the possible reporable gain.

Once each area is computed, the Internal Revenue Code tells us that all gains and losses should be netted to arrive at a net gain or loss. But what about the above situation where the taxpayer reinvested some of the proceeds? The deferred gain is not part of the net reportable gain that would be netted against the losses.

Reporting the loss on Form 4684:

If the remaining two items are combined, the following is the reporting on the Form 4684, resulting in no loss.

				Necklace &
				4 Men’s
				suits
Cost Basis		2		$4,000
Insurance		3		3,880
Gain		4		-
Value before loss		5		1,800
Value after loss		6		0
Loss – (Economic) Line 5 less line 6		7		1,800
Economic loss – smaller of line 2 or line 7		8		1,800
Subtract line 2 from line 8, if zero or less, enter zero -LOSS		9		0

If the items are reportable separately, then there is a net loss of $120 before the $100 adjustment and the reduction of 10% of Adjusted Gross Income.

				Necklace	4 Men’s
					suits
Cost Basis		2		$1,200	$2,800
Insurance		3		1,000	2,880
Gain		4		-	80
Value before loss		5		1,200
Value after loss		6		0
Loss – (Economic) Line 5 less line 6		7		1,200
Economic loss– smaller of line 2 or line 7		8		1,200
Subtract line 2 from line 8, if zero or less, enter zero -LOSS		9		-200	80
Net Loss					-120

The correct reporting would depend on whether the necklace and the 4 men’s suits are of a type that should be combined or reported separately.  In this example, no assertion is made as to the proper method of combination or separation of these items for reporting purposes. The amounts and item descriptions are presented only for exposition purposes.

Another classification in an insurance policy that may apply is Scheduled Property. This is personal property that is itemized in the insurance policy with specific values attached to each item. These items are generally of a type that are high value and are supported by appraisals. In the case of a loss regardless of the fact that the fair market value may have increased since the appraisal, the insurance coverage is limited to the amount listed in the policy. If the antique mirror had been a scheduled property item, it could not be combined with the other three items; it would have to be itemized or combined with other similar scheduled property. The fact that one taxpayer has chosen to specifically insure, schedule, an item in their insurance policy does not mean that it is scheduled in another case where the taxpayer has an identical item that is not scheduled / itemized in the policy.

Finally, what about the small stuff? Some of it can add up to substantial amounts. Here is where insurance and tax diverge. As a taxpayer, the emphasis should be on collecting the maximum amount on the insurance policy. Categories to consider: linens, cloths, kitchen utensils, dishes, pots and pans are examples. To deal with these, make detailed lists, go to the store that you would have purchased the items, in general; get prices and that will be your replacement cost and your insurance claim. Next depreciate those values to consider the time period that you held the items and that will be your cost; then discount the amounts for the used condition at the time of the loss. On this last discount, the IRS would like you to use thrift store prices, but that is not realistic, since you did not actually find it appropriate to donate the items to a thrift store.

Additionally, some items of personal property of high value may require an appraisal. The determination of that aspect of the process is not a part of this analysis.

This blog, “AccountantForDisasterRecovery.com” has been addressing taxpayer income tax issues related to catastrophic losses for more than five years.

All rights to reproduce or quote any part of the chapter in any other publication are reserved by the author. Republication rights limited by the publisher of the book in which this chapter appears also apply.

	JOHN TRAPANI
	Certified Public Accountant
	2975 E. Hillcrest Drive #403
	Thousand Oaks, CA 91362
	(805) 497-4411
	Contact us through our website at:
	www.trapanicpa.com/contact/
	Blog: www.AccountantForDisasteRrecovery.com
	It All Adds Up For You

This material was contributed by John Trapani. A Certified Public Accountant who has assisted taxpayers since 1976, in analyzing and reporting transactions of the type covered in this material.  

Internal Revenue Service Circular 230 Disclosure

This is a general discussion of tax law. The application of the law to specific facts may involve aspects that are not identical to the situations presented in this material. Relying on this material does not qualify as tax advice for purpose of mounting a defense of a tax position with the taxing authorities

The analysis of the tax consequences of any event is based on tax laws in effect at the time of the event.

This material was completed on the date of the posting

© 2013, John Trapani, CPA,