Natural disasters like the one seen over the last two weeks in and around Houston, Texas can cost taxpayers millions of dollars in property damage. Although the tax implications from a major hurricane are the farthest thoughts on a taxpayer’s minds, it is important to discuss these tax situations to make the taxpayer whole. This article will discuss how to calculate a gain or loss from a casualty of personal property and how that will impact ones taxes.
Although this might seem unlikely, taxpayers can actually recognize a gain on the destruction or decrease in fair market value from their home after a natural disaster. This is usually the case when the insurance proceeds exceeds the adjusted basis of the home.
For example, lets say you purchased a home several years ago for $100,000 but at the time leading up to the hurricane or other natural disaster your home was worth $300,000. Now, lets assume the home is completely destroyed and the insurance proceeds amount to $250,000. This means that you would recognize a gain of $150,000 ($250,000 insurance proceeds less $100,000 original basis).
You can exclude this gain from income under the $250,000 exclusion rule ($500,000 married filing joint) and pay no taxes. In order to qualify you must own the property and reside in it for two years during the last five years leading up to the destruction of the property. This does not have to be two consecutive years but instead 730 consecutive or non-consecutive days during a five-year period.
Now, lets assume your insurance proceeds were $700,000 and you have a $600,000 gain; would you still have to pay taxes on the capital gains exceeding the exclusion limits? Not necessarily.
If the taxpayer’s main home is damaged or destroyed and a capital gain is realized, an election may be made to postpone recognizing the gain under the involuntary conversion rules. This can be done by investing in property similar or related in use to the damaged property and meeting other specified requirements.
Generally, the taxpayer has two years to replace the damaged property after the close of the taxable year in which the gain is realized. However, there are circumstances where the time period will be extended if the damaged property is in a federally declared disaster area. This extension period moves the two-year window to a four-year window, and in some cases, even five years.
A casualty loss occurs when the insurance proceeds does not exceed the lesser of the adjusted basis or decrease in fair market value – this sounds complicated but lets look at an example.
Lets say the home was purchased for $100,000 and was valued at $250,000 before the hurricane. Assuming that the fair market value of the home was reduced down to $50,000 then you’d have a reduction in fair market value of $200,000 ($250,000 – $50,000 = $200,000). However, the adjusted basis is less than the reduction in the fair market value so therefore the loss can’t exceed $100,000.
Now lets say the home was purchased for $100,000 and was valued at $125,000 right before the hurricane. The damage from the flooding caused the home to be valued at $50,000 so there is a $75,000 reduction in the fair market value. Since the drop in fair market value is less than the adjusted cost basis then the loss can’t exceed $75,000.
Additionally, it should be noted that any loss should be reduced by any insurance proceeds received. So if the calculated loss is $75,000 but the insurance proceeds equals $70,000 then there is only a $5,000 loss.
This might seem silly, but to calculate the allowable deduction from a casualty loss you will need to reduce each loss by $100. This means that the loss of personal belonging like furniture and the loss from the actual home will be calculated separately. So for each loss that is being claimed you must reduce each amount by $100.
The 10% rule is an additional limitation that reduces the allowable casualty loss by 10% of adjusted gross income (AGI) after factoring in the $100 rule. So, for example, lets say after calculating the allowable loss, factoring in the insurance proceeds and reducing this loss by $100 you are left with a $30,000 loss. Assuming your AGI is $100,000 you must reduce this loss by $10,000 ($100,000 AGI x 10% = $10,000). This reduces your loss down to $20,000 that will be taken as an itemized deduction.
There are several rules and exceptions to the rules when it comes to casualty losses – especially those occurring in a federally designated disaster area. This is why it’s important to discuss these losses, or gains, with a CPA specializing in real estate taxation.