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
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	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,