CHAPTER 17
Casualty and Theft Losses
- Casualties and Thefts
- Condemnations and Threats of Condemnation
- Disaster Losses
- Deducting Property Insurance and Other Casualty/Theft-Related Items
- Certain Disaster Victims
- Disaster Assistance
Floods in Louisiana, Texas and West Virginia, tornadoes and straight-line winds in Arkansas, and fires in California—these are just some examples of the types of weather-related events that can do severe damage to your business property. Terrorist attacks and civil riots are other means of causing damage to business property as are man-made accidents, such as oil spills. If you suffer casualty or theft losses to your business property, you can deduct the losses. You may also suffer a loss through condemnation or a sale under threat of condemnation. Again, the loss is deductible. Certain losses—those from events declared to be federal disasters—may even allow you to recover taxes you have already paid in an earlier year. But if you receive insurance proceeds or other property in return, you may have a gain rather than a loss. The law allows you to postpone reporting of the gain if certain steps are taken.
For further information about deducting casualty and theft losses, see IRS Publication 547, Casualties, Disasters, and Thefts (Business and Nonbusiness) and IRS Publication 2194B, Disaster Losses Kit for Businesses.
Casualties and Thefts
If you suffer a casualty or theft loss to business property, you can deduct the loss. There are no dollar limitations on these losses, as there are on personal losses. Nor are there adjusted gross income (AGI) limitations on these losses, as there are on casualty and theft losses to personal property.
Definition of Casualty
If your business property is damaged, destroyed, or lost because of a storm, earthquake, flood, or some other “sudden, unexpected or unusual event,” you have experienced a casualty. For losses to nonbusiness property (such as your personal residence), the loss must fall squarely within the definition of a casualty loss. Losses to business property need not necessarily satisfy the same definition.
The tax law details what is considered a “sudden, unexpected or unusual event.” To be sudden, the event must be one that is swift, not one that is progressive or gradual. To be unexpected, the event must be unanticipated or unintentional on the part of the one who has suffered the loss. To be unusual, the event must be other than a day-to-day occurrence. It cannot be typical of the activity in which you are engaged.
Examples of Casualties
Certain events in nature automatically are considered a casualty: earthquake, hurricane, tornado, cyclone, flood, storm, and volcanic eruption. Other events have also come to be known as casualties: sonic booms, mine cave-ins, shipwrecks, and acts of vandalism. The IRS has also recognized as a casualty the destruction of crops due to a farmer's accidental poisoning of his fields. Fires are considered casualties if you are not the one who started them (or did not pay someone to start them). Car or truck accidents are casualties provided they were not caused by willful negligence or a willful act.
Progressive or gradual deterioration, such as rust or corrosion of property, is not considered a casualty.
Proof of Casualties
You must show that a specific casualty occurred and the time it occurred. You must also show that the casualty was the direct cause of the damage or destruction to your property. Finally, you must show that you were the owner of the property. If you leased property, you must show that you were contractually liable for damage so that you suffered a loss as a result of the casualty.
Definition of Theft
The taking of property must constitute a theft under the law in your state. Generally, theft involves taking or removing property with the intent to deprive the owner of its use. Typically, this includes robbery, larceny, and embezzlement.
If you are forced to pay extortion money or blackmail in the course of your business, the loss may be treated as a theft loss if your state law makes this type of taking illegal.
If you lose or misplace property, you cannot claim a theft loss unless you can show that the disappearance of the property was due to an accidental loss that was sudden, unexpected, or unusual. In other words, if you misplace property and cannot prove a theft loss occurred, you may be able to deduct a loss if you can establish a casualty was responsible for the loss.
Proof of Theft
You must show when you discovered the property was missing. You must also show that a theft (as defined by your state's criminal law) took place. Finally, you must show that you were the owner of the property.
Determining a Casualty or Theft Loss
To calculate your loss, you must know your adjusted basis in the property.
You also need to know the fair market value (FMV) of the property. If the property was not completely destroyed, you must know the extent of the damage. This is the difference between the FMV of the property before and after the casualty.
How do you determine the decrease in FMV? This is not based simply on your subjective opinion. In most cases, the decrease in value is based on an appraisal by a competent appraiser. If your property is located near an area affected by a casualty that causes your property value to decline, you cannot take this general decline in value into account. Only a direct loss of value may be considered. Presumably, a competent appraiser will be able to distinguish between a general market decline and a direct decline as a result of a casualty. The IRS looks at a number of factors to determine whether an appraiser is competent and his or her appraisal can be relied upon to establish FMV. These factors include:
Familiarity with your property both before and after the casualty
Knowledge of sales of comparable property in your area
Knowledge of conditions in the area of the casualty
Method of appraisal
Remember that if the IRS questions the reliability of your appraiser, it may use its own appraiser to determine value. This may lead to legal wrangling and ultimately to litigation on the question of value. In order to avoid this problem and the costs entailed, it is advisable to use a reputable appraiser, even if this may seem costly to you.
Appraisals used to secure a loan or loan guarantee from the government under the Federal Emergency Management Agency (FEMA) are treated as proof of the amount of a disaster loss. Disaster losses are explained later in this chapter.
You may be able to establish value without the help of an appraiser in certain situations.
If your car is damaged, you can use “blue book” value (the car's retail value, which is printed in a book used by car dealers). You can ask your local car dealer for your car's retail value reported in the blue book (or look it up at www.kbb.com). You can modify this value to reflect such things as mileage, options, and the car's condition before the casualty. Book values are not official, but the IRS has come to recognize that they are useful in fixing value. Of course, if your car is not listed in the blue book, you must find other means of establishing value. Value before the casualty can be established by a showing of comparable sales of similar cars in your area. According to the IRS, a dealer's offer for your car as a trade-in on a new car generally does not establish value.
Repairs may be useful in showing the decrease in value. To use repairs as a measure of loss, you must show that the repairs are needed to restore the property to its precasualty condition and apply only to the damage that resulted from the casualty. You must also show that the cost of repairs is not excessive and that the repairs will not restore your property to a value greater than it had prior to the casualty. Making repairs to property damaged in a casualty can result in double deductions: one for the cost of repairs and the other for the casualty loss.
The last piece of information necessary for determining a casualty or theft loss is the amount of insurance proceeds or other reimbursements, if any, you received or expect to receive as a result of the casualty or theft. While insurance proceeds are the most common reimbursement in the event of a casualty or theft, there are other types of reimbursements that are taken into account in the same way as insurance proceeds. These include:
Court awards for damages as a result of suits based on casualty or theft. Your reimbursement is the net amount of the award—the award less attorney's fees to obtain the award.
Payment from a bonding company for a theft loss.
Forgiveness of a federal disaster loan under the Disaster Relief and Emergency Assistance Act. Typically, these are given under the auspices of the Small Business Administration (SBA) or the Farmers Home Administration (FHA). The part that you do not have to repay is the amount of the reimbursement. Services provided by relief agencies for repairs, restoration, or cleanup are considered reimbursements that must be taken into account.
Repairs made to your property by your lessee, or repayments in lieu of repairs.
What happens if you have not received an insurance settlement by the time you must file your return? If there is a reasonable expectation that you will receive a settlement, you treat the anticipated settlement as if you had already received it. In other words, you take the expected insurance proceeds into account in calculating your loss. Should it later turn out that you received more or less than you anticipated, adjustments are required in the year you actually receive the insurance proceeds, as explained later in this chapter.
If the amount of insurance proceeds or other reimbursements is greater than the adjusted basis of your property, you do not have a loss. Instead, you have a gain as a result of your casualty or theft loss. How can this be, you might ask? Why should a loss of property turn out to be a gain for tax purposes? Remember that your adjusted basis for business property in many instances reflects deductions for depreciation. This brings your basis down. But your insurance may be based on the value of the property, not its basis to you. Therefore, if your basis has been adjusted downward for depreciation but the value of the property has remained constant or increased, your insurance proceeds may produce a gain for you. Gain and how to postpone it are discussed later in this chapter.
Calculating Loss When Property is Completely Destroyed or Stolen
Reduce your adjusted basis by any insurance proceeds received or expected to be received and any salvage value to the property. The result is your casualty loss deduction. The FMV of the property does not enter into the computation.
If the casualty or theft involves more than one piece of property, you must determine the loss (or gain) for each item separately. If your reimbursement is paid in a lump sum and there is no allocation among the items, you must make an allocation. The allocation is based on the items’ FMV before the casualty.
Calculating Loss When Property is Partially Destroyed
Calculate the difference between the FMV of the property before and after the casualty. Reduce this by any insurance proceeds. Compare this figure with your adjusted basis in the property, less any insurance proceeds. Your casualty loss is the smaller of these two figures.
If you lease property from someone else (e.g., if you lease a car used for business), your loss is limited to the difference between the insurance proceeds you receive, or expect to receive, and the amount you must pay to repair the property.
Inventory and Crops
Typically, a casualty or theft to inventory is not treated as a separate loss. Instead, the amount of opening and closing inventories for cost of goods sold is increased, and any insurance or other recovery for the loss is taxable. You can, however, opt to take the loss separately; the loss deduction must be reduced by any insurance or other reimbursement received. If you deduct the loss, then adjust the opening inventory or purchases to remove the loss items (so they are not counted twice).
In the case of crops, the cost of raising them has already been deducted, so no additional deduction is allowed if they are damaged or destroyed by a casualty.
Recovered Property
What happens if you deduct a loss for stolen property and the property is later recovered? Do you have to go back and amend the earlier return on which the theft loss was taken? The answer is no. Instead, you report the recovered property as income in the year of recovery.
But what if the property is not recovered in good shape or is only partially recovered? In this instance, you must recalculate your loss. You use the smaller of the property's adjusted basis or the decrease in the FMV from the time it was stolen until you recovered it. This smaller amount is your recalculated loss. If your recalculated loss is less than the loss you deducted, you report the difference as income in the year of recovery. The amount of income that you must report is limited to the amount of loss that reduced your tax in the earlier year.
Insurance Received (or Not Received) in a Later Year
If you had anticipated the receipt of insurance proceeds or other property and took that anticipated amount into account when calculating your loss but later receive more (or less) than you anticipated, you must account for this discrepancy. As with recovered stolen property, you do not go back to the year of loss and make an adjustment. Instead, you take the insurance proceeds into account in the year of actual receipt.
If you receive more than you had expected (by way of insurance or otherwise), you report the extra amount as income in the year of receipt. You do not have to recalculate your original loss deduction. The additional amount is reported as ordinary income to the extent that the deduction in the earlier year produced a tax reduction. If the additional insurance or other reimbursement, when combined with what has already been received, exceeds the adjusted basis of your property, you now have a gain as a result of the casualty or theft. The gain is reported in the year you receive the additional reimbursement. However, you may be able to postpone reporting the gain, as discussed later in this chapter.
If you receive less than you had anticipated, you have an additional loss. The additional loss is claimed in the year in which you receive the additional amount.
Basis
If your property is partially destroyed in a casualty, you must adjust the basis of the property:
Decrease basis by insurance proceeds or other reimbursements and loss deductions claimed.
Increase basis by improvements or repairs made to the property to rebuild or restore it.
Year of the Loss
In general, the loss can be claimed only in the year in which the casualty or other event occurs. However, in the case of the theft, the loss is treated as having occurred in the year in which it is discovered.
Coordination with Repairs
You cannot take both a casualty loss deduction and a deduction for repair costs. If you claim a casualty loss deduction, then no deduction can be taken for repair costs, even if the amount of the casualty loss relative to the repair expenditure is small.
Condemnations and Threats of Condemnation
The government can take your property for public use if it compensates you for your loss. The process by which the government exercises its right of eminent domain to take your property for public use is called condemnation. In a sense, you are being forced to sell your property at a price essentially fixed by the government. You can usually negotiate a price; sometimes you are forced to seek a court action and have the court fix the price paid to you. Typically, an owner is paid cash or receives other property upon condemnation of property.
Sometimes the probability of a condemnation becomes known through reports in a newspaper or other news medium or proposals at a town council meeting. For example, there may be talk of a new road or the widening of an existing road that will affect your property. If you do not voluntarily sell your property, the government will simply go through the process of condemnation.
Where there is a condemnation, you may also voluntarily sell other property. If the other property has an economic relationship to the condemned property, the voluntary sale can be treated as a condemnation.
Not every condemnation qualifies for special tax treatment. When property is condemned because it is unsafe, this is not a taking of property for public use. It is simply a limitation on the use of the property by you.
For tax purposes, a condemnation or threat of condemnation of your business property is treated as a sale or exchange. You may have a gain or you may have a loss, depending on the condemnation award or the proceeds you receive upon a forced sale. But there is something special in the tax law where condemnations are concerned. If you have a gain, you have an opportunity to avoid immediate tax on the gain. This postponement of reporting the gain is discussed in Chapter 6.
Condemnation Award
The amount of money you receive or the value of property you receive for your condemned property is your condemnation award. Similarly, the amount you accept in exchange for your property in a sale motivated by the threat of condemnation is also treated as your condemnation award. The amount of the condemnation award determines your gain or loss for the event.
If you are in a dispute with the city, state, or federal government over the amount that you should be paid and you go to court, the government may deposit an amount with the court. You are not considered to have received the award until you have an unrestricted right to it. This is usually after the court action is resolved and you are permitted to withdraw the funds for your own use.
Your award includes moneys withheld to pay your debts. For example, if the court withholds an amount to pay a lien holder or mortgagee, your condemnation award is the gross amount awarded to you, not the net amount paid to you.
The condemnation award does not include severance damages and special assessments.
Treatment of Severance Damages
Severance damages are not reported as income. Instead, they are used to reduce the basis of your remaining property. However, only net severance damages reduce basis. This means that you must first subtract from severance damages any expenses you incurred to obtain them. You also reduce severance damages by any special assessments levied against your remaining property if the special assessments were withheld from the award by the condemning authority. If the severance damages relate only to a specific portion of your remaining property, then you reduce the basis of that portion of the property.
If the net severance damages are greater than your basis in the remaining property, you have a gain. However, you can postpone reporting the gain, as discussed in Chapter 6.
Generally, you and the condemning authority will contractually agree on which portion of an award is for condemnation and which part, if any, is for severance damages or other awards. This allocation should be put in writing. You cannot simply go back after the transaction is completed and try to make an allocation. You may, however, be able to convince the IRS that the parties intended to make a certain allocation if the facts and circumstances support this argument. If there is no written allocation and you cannot convince the IRS otherwise, all of the amounts received will be treated as a condemnation award (and no part will be treated as severance damages).
Treatment of Special Assessments
Special assessments serve to reduce the condemnation award. They must actually be withheld from the award itself; they cannot be levied after the award is made, even if it is in the same year.
If a condemnation award includes severance damages, then the special assessments are first used to reduce the severance damages. Any excess special assessments are then used to reduce the condemnation award.
Disaster Losses
In the past several years, our country has experienced a large number of major disasters, including hurricanes, floods, fires, blizzards, earthquakes, and terrorist attacks. When large areas suffer sizable losses, the president may declare the areas eligible for special federal disaster relief. This disaster assistance comes in the form of disaster relief loans, special grants (money that does not have to be repaid), special unemployment benefits, and other types of assistance. Still, despite all these efforts by the federal government, as well as state, local, and private agencies, you may experience serious disruption to your business and loss to your business property. The tax law provides a special rule for certain disaster losses that will give you up-front cash to help you get back on your feet.
Typically, you deduct your loss in the year in which the disaster occurred. However, you may elect to deduct your loss on a prior year's return, which can result in a tax refund that may provide you with needed cash flow.
If your loss occurs later in the year, after you have already filed your tax return for the prior year, you can still get a tax refund by filing an amended return for the prior year. For example, if in the Example your loss occurred in December 2017 (after you filed your 2016 return), you can file an amended return for 2016 to claim the disaster loss.
You must make the election to claim the loss on the prior year's return by the later of:
The due date (including extensions) for filing your income tax return for the year in which the disaster occurred, or
The due date (including extensions) for the preceding year's return.
Not all seeming disasters qualify for this special tax election. To be treated as a disaster, your loss must have resulted from a casualty in an area declared to be eligible for federal disaster assistance.
If you suffer a loss in your inventory due to a disaster, you need not account for your loss simply by a reduction in the cost of goods sold. Instead, you can claim a deduction for your loss. The loss can be claimed on the return for the year of the disaster or on a return (or amended return) for the preceding year. If you choose to deduct your inventory loss, then you must also reduce your opening inventory for the year of the loss so that the loss is not also reflected in the inventory; you cannot get a double benefit for the loss.
If you suffer a net operating loss (NOL) and you are in a federally-declared disaster area, you can carry the NOL back for 3 years (rather than the usual 2 years) to obtain a tax refund (see Chapter 4).
The IRS has a landing page entitled Disaster Assistance and Emergency Relief for Individuals and Businesses at www.irs.gov/businesses/small-businesses-self-employed/disaster-assistance-and-emergency-relief-for-individuals-and-businesses-1. Here you will find helpful links to publications and other disaster-related information.
Deducting Property Insurance and Other Casualty/Theft-Related Items
It is well and good that you can write off your casualty and theft losses. But as a practical matter, you should carry enough insurance to cover these situations so that you will not suffer any financial loss should these events befall your business. If you carry insurance to cover fire, theft, flood, or any other casualty related to your business, you can deduct your premiums (see Chapter 22).
If you maintain a home office, you must allocate the cost of your homeowner's policy and deduct only the portion allocated to the business use of your home as part of your home office deduction, assuming you use the actual expense method for figuring this deduction (as discussed in Chapter 18). Be sure to check your homeowner's policy to see that it covers your business use. You may have to obtain additional coverage if you use your home for certain types of business activities. For example, if clients or customers come to your home, it may be advisable to increase your liability coverage. The cost of additional coverage for business guests (which may be in the form of a rider to your policy) may be rather modest. Similarly, your homeowner's policy may not cover business equipment or other business property in your home office (e.g., computer, inventory). Again, a small rider may be necessary to protect you against equipment loss.
If you are a manufacturer who includes business insurance as part of the cost of goods sold, no separate deduction can be taken for these insurance premiums.
If you self-insure to cover casualty or theft by putting funds aside, you cannot deduct the amount of your reserves. In this case, only actual losses are deductible, as explained earlier in this chapter. Self-insurance may be advisable to cover certain casualties that may not be covered by your policy. For example, your policy may not cover damage from civil riots. Self-insurance is also a good idea where you have a high deductible (for example, a state-prescribed deductible for flood insurance in a coastal area). Be sure to review carefully your policy's exclusions (the types of events not covered by your insurance).
Use and Occupancy Insurance
If you carry insurance to cover profits that are lost during a time you are forced to close down due to fire or other cause, you may deduct the premiums. If you then do shut down and collect on the insurance, you report the proceeds as ordinary income.
Car Insurance
The same rule that applies to business property insurance also applies to insurance for your car or other vehicles used in your business. This insurance covers liability, damages, and other losses in accidents involving your business car. However, if you use your car only partly for business, you must allocate your insurance premiums. Only the portion related to business use of your car is deductible. The portion related to personal use of your car is not deductible.
If you use the standard mileage allowance to deduct expenses for business use of a car, you cannot deduct any car insurance premiums. The standard mileage rate already takes into account an allowance for car insurance. Deductions for various types of insurance are discussed in greater detail in Chapter 22.
Appraisals
If your property is damaged by a casualty and you pay a qualified appraiser to establish the FMV of the property in order to prove your damage and the extent of your loss, you claim a separate deduction for appraisal fees. You do not take the appraisal fees into account when calculating your casualty loss deduction.
Certain Disaster Victims
If your business is located in an area affected by certain storms, or other federal disasters, you may be eligible for special tax breaks. These include additional time for filing certain returns and paying certain taxes, increased write-offs for certain property purchases (intended to restore the area following the disaster), and an extended net operating loss carryback. These breaks are discussed in relevant sections throughout this book.
Disaster Assistance
Tax rules can certainly ameliorate losses resulting from disasters impacting your business. However, planning to avoid or mitigate a disaster and having monetary assistance, in the form of loans and grants, may be more helpful. Usually, disaster mitigation payments, grants, and other similar payments to businesses are taxable (an exclusion for qualified disaster mitigation payments apply only to individuals). Some resources for disaster help:
Farm Services Agency (FSA). The Agricultural Act of 2014 indefinitely extended the four disaster programs that were previously authorized by the Food, Conservation, and Energy Act of 2008. Find details at www.fsa.usda.gov/FSA/webapp?area=home&subject=diap&topic=landing.
FEMA. FEMA has a disaster relief fund, which consists of appropriations that it can direct to states for disaster assistance; it does not provide any direct relief for businesses, but does offer disaster planning continuity planning templates to help you plan for a disaster (go to www.fema.gov/planning-templates).
SBA loans. Two low-interest loan programs—Disaster Loans and Economic Injury Loans—are available for small businesses impacted by a federal disaster. Find details at www.sba.gov.
State government. Your state can help to plan and may provide disaster recovery assistance. Find links to your state from www.sba.gov/content/state-government-information.
Find links to many resources through DisasterAssistance.gov at www.disasterassistance.gov.
Employees
Casualty and theft losses to business property are calculated in Section B of Form 4684, Casualty and Theft Worksheet for Individuals. Losses are then netted against gains and are entered on Form 4797, Sales of Business Property. Your losses are entered directly on page 1 of Form 1040. They are not taken on Schedule A, as are casualty and theft losses to personal property (such as your personal residence). Nor are they limited by the $100 per casualty or 10%-of-adjusted-gross-income limitation that applies to casualty and theft losses to nonbusiness property.
If the casualty or theft happened to property used for both business and personal purposes, you must make an allocation. Only the business portion of the loss is free from the $100/10% limitations. For example, if you use a car 75% for business and 25% for personal purposes and the car is totaled in an accident for which you do not have collision insurance, 75% of your loss (the business portion) is claimed without regard to the $100/10% limits; the other 25% of your loss (the personal portion) is subject to both the $100 and 10% limits.
Self-Employed
Casualty and theft losses to business property are calculated in Section B of Form 4684. Losses are then netted against gains and are entered on Form 4797. The net result is then entered on page 1 of Form 1040; you do not enter the amount on Schedule C.
Losses from involuntary conversions are netted against gains and losses from Section 1231 property. This is essentially depreciable property, used in a trade or business and held for more than one year, that is not held for inventory or for sale to customers in the ordinary course of business. (Certain livestock, crops, timber, coal, and domestic iron ore can also be Section 1231 property.) Thus, even if you have a casualty loss, you may not get the benefit of the loss if you have gains from the sale or exchange of Section 1231 property. However, losses to inventory are taken into account in the cost of goods sold.
Partnerships and LLCs
The partnership or LLC reports income or loss from an involuntary conversion (casualty, theft, or condemnation) on Form 4797. The net gain or loss is taken into account when arriving at the total trade or business income or loss on Form 1065 on the specific line provided for net gain or loss from Form 4797.
Even if you are a silent partner in an activity that is treated as a passive activity, casualty and theft losses are not subject to the passive loss limitations. You may claim these losses as long as they are not a recurrent part of the business.
S Corporations
If the S corporation has income or loss from an involuntary conversion (casualty, theft, or condemnation), it must file Form 4797. The net gain or loss is taken into account in arriving at the S corporation's total trade or business income or loss on Form 1120S. Net gain or loss from Form 4797 is reported on the specific line provided on Form 1120S for this purpose.
Even if you are a silent partner in an activity that is treated as a passive activity (a shareholder who does not materially participate in the business), casualty and theft losses are not subject to the passive loss limitations. You may claim these losses as long as they are not a recurrent part of the business.
C Corporations
C corporations report net gains or losses from involuntary conversions on Form 4797 and then use the net amount to arrive at taxable income on Form 1120. Net gains or losses from Form 4797 are reported on the specific line provided on Form 1120 for this purpose.