PROCESS
OF RECOVERING FROM A CATASTROPIC LOSS
INCOME
AND PROPERTY TAXES CONSEQUENSES AND REQUIREMENTS
PART
2
7
NO GAIN OR LOSS
8 A
LOSS
7 NO GAIN OR LOSS
The potential and actual tax
consequences must be understood prior to making any replacement decisions and
the process afterward. There is some flexibility in making changes to decisions
later, See “Things Can Get Worse”
section 15.
It
is possible that the initial analysis results in no gain or loss. Yes that is
possible. If insurance is adequate, the loss was not total and the cost basis
is the result of a recent acquisition of the property.
Even
it there is no gain or loss, it is advised that the following information
should be part of the disclosures included in a tax return related to a
catastrophe:
- The type of casualty and when it occurred (including, if available, the FEMA identification number).
- The date of the loss.
- That the loss was a direct result of the casualty.
- The information relates to the return for the taxpayer who owns the property (or the taxpayer is leasing and is contractually liable to the owner for the damage.)
- The city, county and state in which the loss event occurred.
- Any replacement costs incurred, appropriately detailed.
- Cost basis of property damaged.
- Insurance proceeds received or expected to be received.
If the gross loss does not exceed $10,100, and
the taxpayer’s adjusted gross income is $100,000, no deduction would be
allowed. The facts should be disclosed in the return. The above items should be
reported.
Odd as it may seem, there are other
possible ways to have neither a loss nor a gain. It may even be possible that
there is a gain, but due to the application of available exclusions, there is
no realized gain. If the cost basis of the property is close to the insurance
recovery and the insurance is reasonably adequate, there is a good chance,
there will be no loss or gain realized for income tax purposes.
If there is a gain, but the residence
qualified as a complete loss, triggering the Internal Revenue Code section 121
exclusion of gain, $250,000 for the taxpayer and $250,000 for the spouse. A
gain of less than $500,000 for a married couple eliminates the gain, but it
results in no gain or loss. It does require the filing of a complete statement
to claim the exclusion. The above items should be reported.
When computing a loss the cost basis
that is used is based on the “adjusted cost basis” as described above. Because
of that, an initial loss based on actual cost basis may evaporate when the
actual cost basis is replaced with the “adjusted cost basis.” If that
computation turns into a gain using “adjusted cost basis,” there would be no
gain to report and no loss.
8 A
LOSS
There are instances where it is
necessary to determine who is entitled to claim any deduction for the loss.
When to deduct a loss:
In order to claim a deduction the Code
requires that the loss must be sustained. To be sustained, the loss must have
occurred and the claims process, settled. There is some vagary in the meaning
of settled. Assume a loss of $1,200,000. The maximum possible insurance
coverage that is available to pay for the loss is $800,000. The insurance
company has paid out only $200,000 by the time that the tax return is due for
the year in which the loss occurred. There is every likelihood that the balance
of the policy limits will be paid. There is no certainty that any loss in
excess of the limits will be recouped from insurance or that any claim for
additional loss is even possible. Under this situation, it may be reasonable to
take the position that the loss of $400,000 in excess of the policy limits of
$800,000 has been settled.
Without going into a long analysis, if
the loss is $150,000 and the insurance will only cover $100,000, then it can be
argued that $50,000 is sustained even if the claim process is not yet
completed. If the insurance company pays only $95,000 on the claim, then an
additional $5,000 would be deductible in the year that the $95,000 is
finalized.
The loss and cost basis are reduced by
insurance proceeds. The loss can be determined using one of two methods
discussed below.
APPRAISAL
METHOD vs. COST OF REPAIRS METHOD
Documenting a loss is accomplished
using the “Appraisal Method” or the “Cost of Repairs Method.”
For the “Cost of Repairs Method” only
the cost of the repairs necessary to return the property to its pre-event
condition is compared to the Adjusted Cost Basis of the property damaged; the
lower of the two amounts is the loss. Using the Cost of Repairs Method, the
cost of removing the debris would be one of the amounts leading to the total
cost of repairs. The deduction can only be taken once the repairs have been
completed. If the repairs are completed in a year subsequent to the year of the
event, once they are completed, the taxpayer would file a return for the year
of the of completion, claiming the loss. The drawback of the Cost of Repairs
Method is that the repairs must be made and only those repairs that return the
property to its pre-event condition are permitted to be included in the
computation of the loss. Any improvements or betterments, either required or
elective, are not allowed as part of the cost of repairs calculation of the
loss.
Selecting the “Cost of Repairs Method”
does not alleviate the need for an appraisal. The value immediately before the
event must still be determined to establish the lower of actual cash investment
or appraised value for determining the adjusted cost basis before the loss event.
Using the Cost of Repairs Method also
limits the taxpayer from reinvesting the insurance funds in a separate
replacement property to qualify as replacement of the damaged property.
“Betterments” can and should be incorporated into the repair, but the cost of
the betterment do not qualify as a cost for computing the amount of the loss.
In some cases, a repair may be called for that is demanded by the building
code, but does not duplicate the original construction. Even though it may cost
the same as returning the property to substantially its original configuration,
it will not count as the IRS will likely view it as a disqualified improvement.
Where a taxpayer has made a decision to
epoxy a cracked slab and use the cost savings to upgrade a kitchen, the upgrade
would be excluded from the computation of the allowable loss. Since the
concrete slab will not be replaced, its cost of replacement included in the
insurance claim is not part of the loss computation either.
Under the law the details of the repairs
used to quantify the loss using the “Cost of Repairs Method” must be traced to
the completion of the repairs within a reasonable period of time after the
event, considering the completion of the insurance claims process.
All of the restrictions inherent in the
Cost of Repairs Method disappear when using the “Appraisal Method” for
determining the loss. Under the “Appraisal Method,” the taxpayer simply gets
two appraisals prepared by a competent, qualified real estate appraiser. The
first appraisal computes the value immediately before the loss event occurred.
The second computes the value giving effect to the fact that the loss has
occurred.
The second appraisal should specify and
include the detrimental effects on the fair market value due to the debris that
is present after the event. It should also specify that i
“The post-event
appraisal does not give effect to any temporary buyer resistance that may be
impacting the market immediately after the event.”
The appraiser need not compute the
difference between the two amounts. To arrive
at the Appraisal Loss the requirements are entered on Form 4684. The Appraisal
Loss is compared to the “Adjusted Cost Basis,” discussed below. The loss is the
lower of the Adjusted Cost Basis or the Appraisal Loss. The loss and cost basis
are reduced by any applicable insurance proceeds.
Using the Appraisal Method allows the
taxpayer to use insurance funds for the repair and improvement of the damaged
property or the acquisition of a replacement property. (The insurance contract
may impose separate limitations.) There are no income tax limitations placed on
the location of the replacement property. It does not even have to be located
in the same state.
Expert personal property appraisers may
be able to approximate the original cost and pre-event value of some contents.
Caution:
The taxpayer may think that providing
the appraiser with a copy of the scope of loss will assist the appraiser in
determining the value of the property after the event. The cost of repairs is
not necessarily relevant to the appraiser’s valuation analysis for the
pre-event value and the destroyed structure is irrelevant to the land value
after the event. The appraiser will make an independent determination of the
value of a partially destroyed structure.
The risk of providing the scope of
loss to the appraiser is that if the appraiser includes any reference
directly or indirectly to the scope of loss, while the taxpayer has selected
the “Appraisal Method,” the IRS, in an audit may incorrectly assert that the
“Cost of Repairs Method” has been selected. The IRS has lost on this
allegation. The courts allow the appraiser to use his / her expert judgment
to arrive at the estimate of value. But while the IRS has lost on this
scenario that does not mean that the auditor you are facing will know that.
It potentially adds an additional item that must be dealt with in an audit
that can be avoided.
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Determining a loss
If there is a loss, the taxpayer must
take care in determining the loss including which method of computation to use.
Determination of the loss is based on one of the two methods of computation.
The choice of method is left to the taxpayer, although the IRS has been known
to question the outcome and attempt to use another method. Generally, the
taxpayer’s choice has been upheld if it has been properly supported. The IRS
will prevail over taxpayers who have been loose with the accumulation of proper
supporting evidence. The two methods of determining the amount of the loss are
quite different. The Appraisal and Cost of Repairs Method s will not provide
equivalent results. In fact, it is likely that they will result in quite
disparate amounts.
The loss computed using either method
cannot exceed the adjusted cost basis of the property.
Reporting
a Loss – FORM 4684
It must be determined in what tax year
will the loss be reported on a tax return. Assume the loss occurs near the end
of the year. The claims process can be complicated and may extend past the end
of the year subsequent to the year that the event occurred.
Once the basic amount of the loss is
determined, there are two adjustments that reduce the amount of the tax
deduction. The first is that $100 for each event during the year is excluded.
The amount of income that appears at the bottom of page one of the Form 1040
income tax return is called “Adjusted Gross Income” (AGI). The second
adjustment requires that 10% of AGI must be deducted from the total of all
casualties reported for the year. If the pre-adjustment losses total $50,000, all
from one event, and AGI for the year is $100,000, the deductible loss will be
$39,900 ($50,000 less $100, less 10% of $100,000).
The
IRS has a number of useful booklets for taxpayers who experience a
catastrophic physical event. The IRS has combined a number of these separate
publications in two publications,
2194 for
individuals and 2194b for
businesses.
The
booklets can be accessed on the IRS website at www.irs.gov.
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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
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Certified
Public Accountant
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2975
E. Hillcrest Drive #403
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Thousand
Oaks, CA 91362
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(805)
497-4411 E-mail John@TrapaniCPA.com
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Website: www.TrapaniCPA.com
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Blog:
www.AccountantForDisasteRrecovery.com
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It All Adds Up For You
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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
© 2011, 2012 & 2013, John Trapani, CPA,
