Benefit

If you suffer damage to personal‐use property due to a casualty or theft, any insurance proceeds you recover are tax free. If you have a loss in a federally declared disaster area that is not fully covered by insurance or other reimbursements, you may be able to take a deduction for your loss. Depending on the type of disaster loss, you may be able to deduct it even if you claim the standard deduction; other disaster losses are only deductible by those who itemize. There is no overall dollar limit on the amount you can deduct.

The amount of your disaster loss, however, is limited to the decrease in the value of property from the casualty or its adjusted basis (usually your cost), whichever amount is smaller.

Rule of thumb: For property that appreciates in value, your loss is usually based on your adjusted basis; for property that declines in value, your loss is usually based on the decrease in value.

Conditions

To deduct a loss relating to your personal‐use property, such as your home or car, you must meet all 4 of these conditions:

1. The loss must result from a federally declared disaster.
2. You must have proof of the loss.
3. You must reduce your loss by any insurance or other reimbursements.
4. The amount of your loss must exceed certain limits if the loss is exclusive to personal items (there are no such limits for business losses).

Planning Tips

How do you determine the decrease in value? There are a few alternatives:

• Obtain an appraisal. Use a qualified appraiser to determine the value of the property before and after the casualty (the tax treatment of appraisal fees is discussed later in this chapter).
• Use the cost of repairs or restoration as the measure of loss. You can rely on this cost if the repairs are necessary to bring the property back to its precasualty condition, the amount spent is not excessive, and the value of the property after the repairs is not more than it was before the casualty.
• If the loss involves your car, you can use various online valuation services to determine the value of your car, including Kelley Blue Book (www.kbb.com) and NADA Appraisal Guides (www.nadaguides.com).

If you are married and one spouse suffers a casualty loss (for example, an expensive uninsured piece of jewelry is lost in a disaster), it may be advisable to file separate returns. This is so where the spouse with the lower AGI suffers the loss. The lower AGI may entitle the spouse to a deduction that would otherwise be blocked because of the couple's combined AGI. Of course, other factors must be taken into account when filing separate returns, such as eligibility to claim other tax benefits that require filing a joint return.

Review your insurance coverage carefully to understand what it does and does not cover. You may be able to expand the coverage under your existing policy; or you may need to obtain other coverage (for example, flood insurance if you are located within a flood zone). In some cases, you may not be able to obtain coverage because it is just not sold or the premiums are prohibitive. For example, even though federal legislation has provided underwriting guarantees to carriers for claims due to terrorist attacks, many major carriers are simply not covering such events.

Which year should you claim the loss—the year of the disaster or the prior year? Generally, choose the year in which you have a lower adjusted gross income threshold for figuring your loss.

If your home and its contents are damaged or destroyed in a disaster, figure the loss separately for the home and for the furnishings.

If you are living in a federal disaster area, you may be entitled to certain tax breaks, even if you don't qualify to claim a disaster loss (you might be fully compensated by insurance or might not have had any loss). For example, you may be eligible for a 6‐month postponement of tax deadlines. The IRS may also abate the interest and penalties on underpayment of income tax for the length of any postponement of tax deadlines.

If you have a loss that isn't from a disaster, you can use it to offset gain from a casualty or theft. Such gain results when insurance proceeds exceed the adjusted basis of the damaged or destroyed property.

If you are a disaster victim, you may have more time to take certain tax actions. There's an automatic 60‐day extension for completing various time‐sensitive tax actions (e.g., filing returns, completing an IRA rollover) and the IRS has authority to grant additional time (up to one year) for filing returns and certain other tax actions. Check the IRS website at https://www.irs.gov/newsroom/tax-relief-in-disaster-situations for extensions and other disaster relief.

Pitfalls

Not all losses related to a disaster are deductible. You cannot deduct your personal living expenses in temporary housing when a disaster forces you out of your home. You cannot deduct cleanup costs from the disaster.

Your deduction is limited to your economic loss. You cannot recoup anything related to sentimental value.

Where to Claim the Deduction

You must file Form 4684, Casualties and Thefts, to report the loss and figure the amount of the deduction. The deduction is then entered on Schedule A of Form 1040 or 1040‐SR.

If you are itemizing deductions, the disaster loss is entered on line 15 of Schedule A. If you do not itemize but have a net qualified disaster loss, you enter the amount on line 16 of Schedule A, with adding on the dotted line “Net Qualified Disaster Loss.” Also, on Line 16, list your standard deduction amount (see the Introduction) and add “Standard Deduction Claimed with Qualified Disaster Loss.” Combine the 2 amounts (net qualified disaster loss and standard deduction amount), which is then entered on Form 1040 or 1040‐SR.

If you are claiming a disaster loss for the prior year for which you have not yet filed a return (for example, in January 2023 you have a casualty loss that you report on your 2022 return to be filed by April 18, 2023), note at the top of the return “DISASTER LOSS.” If you are claiming a disaster loss for the prior year for which you have already filed a return, you must file an amended return, Form 1040‐X. At the top of the return note “DISASTER LOSS.”

Benefit

You are not taxed on disaster relief payments you receive from federal agencies or charitable organizations to cover personal expenses. There is no dollar limit on the amount you can exclude from income. Your exclusion does not depend on your income or need.

Conditions

Only “qualified disaster relief payments” are excludable. These include payments, regardless of the source, for the following reasonable and necessary expenses:

• Personal, family, living, or funeral expenses incurred as a result of a presidentially declared disaster.
• Expenses incurred for the repair or rehabilitation of a personal residence due to a presidentially declared disaster (whether you own the home or rent it as a tenant).
• Expenses incurred for the repair or replacement of the contents of a personal residence due to a presidentially declared disaster.

Grants under the Disaster Relief and Emergency Assistance Act are excludable from income, but you cannot deduct a disaster loss to the extent you are reimbursed for it by the grants. Cancellation of all or part of a federal disaster loan is also considered reimbursement for a loss (it reduces your casualty loss deduction).

Disaster relief mitigation payments are also excludable from income. These are payments made under the Robert T. Stafford Disaster Relief and Emergency Assistance Act or the National Flood Insurance Act for hazard mitigation of your property, such as to elevate or relocate flood‐prone homes.

Planning Tip

If you are the victim of a disaster, be sure to check with your local authorities as well as with FEMA to see whether there are any grants or relief payments you may be entitled to.

Pitfall

Disaster relief payments for business‐related expenses, lost wages, or unemployment compensation may not be excluded from income and are fully taxable.

Where to Claim the Benefit

Since qualified disaster relief payments are not taxable, you do not have to report them on your return.

Benefit

If you receive compensatory damages for personal physical injury or illness, you can exclude your recovery. For example, if you recover damages for a medical malpractice incident that affected your body, the damages are tax free. There is no dollar limit on the amount you can exclude from income.

There is a special exclusion for persons who were persecuted by the Nazis. They can exclude all amounts received as restitution payments for their ordeal. The exclusion applies to:

• Heirs or estates of such persons who suffered on the basis of their race, religion, physical or mental disability, or sexual orientation.
• Restitution payments for assets that were lost or stolen before or during World War II.
• Life insurance issued by European insurance companies immediately before and during the war.
• Interest earned on escrow accounts and funds established in settlement of Holocaust victim claims.

There is a special exclusion for restitution for victims of human trafficking. Even though the restitution payments are not limited to physical injury, the payments are fully excludable.

There is also a special exclusion for compensation paid to the wrongfully incarcerated even though the payments do not relate to physical injury. All of the payments received for wrongful incarceration are tax free.

Damages arising out of the purchase of property are treated as a recovery for injury or damage to a capital asset. As such, damages are tax free to the extent of your basis in the property.

If you receive damages for any other reason, including punitive damages for physical injury or any type of damages for personal injury that is not physical, the damages are fully taxable. Nonphysical personal injuries for which damages are taxable include injury to reputation, discrimination, and back pay.

Conditions

To claim the exclusion for damages, the award must relate to some physical injury or sickness. Damages for emotional distress are excludable only if they are attributable to a physical injury or sickness.

“Soft injuries,” such as headaches, weight loss, and insomnia, arising from a work‐related case (e.g., discrimination, sexual harassment) are viewed as emotional distress and not as physical injuries for which damages are tax free. However, any awards for these soft injuries are excludable to the extent they compensate for medical costs.

The damages must be compensatory, meaning that they aim to make you whole from your loss (covering medical expenses, etc.). Punitive damages are not tax free, even if they relate to physical injuries.

The damages award can be a negotiated settlement or an award fixed by a court.

Planning Tip

If an action involved both physical and nonphysical injury aspects, be sure that the complaint allocates the degree of injury to each part.

Pitfalls

If you receive interest on an award for physical damages, you are taxed on the interest even though the award itself is tax free.

If you obtain a recovery under a contingent fee agreement with your attorney, you must include the entire award in income if such awards are taxable (e.g., defamation actions). How you treat the attorney's fees depends on the nature of the action (see Chapter 15).

Where to Claim the Benefit

Since damages for personal physical injury are excludable from your income, you do not have to report them on your return.

If you receive damages for personal injuries that are not physical (for example, for libel), they are taxable and must be reported as “Other income” on Schedule 1 of Form 1040 or 1040‐SR.

Benefit

Disability benefits you receive under a policy on which you paid the premiums are tax free. There is no dollar limit on the amount of disability benefits you can exclude from income. If your employer paid the premiums on a policy that you are now collecting on, the benefits are taxable to you. If you and your employer shared the cost of premiums, you must allocate the benefits accordingly; you can exclude only the portion that relates to your payments.

Disability coverage under Social Security is treated for tax purposes in the same way as Social Security retirement benefits—they may be wholly excludable or included in income in the amount of 50% or 85% of benefits, depending on your filing status and income. Generally, the payment of disability benefits under Social Security ends once you attain your full retirement age (for example, 66 years old for someone born in 1943 through 1954; the age increases gradually until it reaches 67 for those born after 1959). At that time you start receiving Social Security retirement benefits.

Condition

Tax‐free treatment applies to benefits paid under a policy for which you paid the premiums with after‐tax dollars. Tax‐free treatment also applies to these types of disability payments:

• Disability pensions from the Department of Veterans Affairs
• Pensions for combat‐related injuries or injuries from a terrorist attack
• Disability pensions for anyone who has injuries resulting from terrorist attacks after September 10, 2001

Planning Tips

If your employer gives you the choice between accepting employer‐paid disability coverage or paying for such coverage yourself, you may prefer to pay for it so that benefits will be tax free if you become disabled. While your employer's payment of disability insurance premiums may be tax free to you, the price for this benefit is taxability of any disability payments you later receive.

If you are totally and permanently disabled and receive little or no Social Security benefits, you may be eligible for a tax credit called the credit for the elderly and disabled.

Pitfall

If you retire on disability and receive a lump‐sum payment for accrued annual leave, you cannot exclude this payment; it is fully taxable as additional compensation.

Where to Claim the Benefit

If you are entitled to exclude disability payments you receive, you do not have to report them on your return.

Taxable disability pension payments shown on Form 1099‐R are reported on your return as compensation if you have not reached the minimum retirement age set by your employer (use the same line you would for reporting salary, wages, etc.). Once you have attained the minimum retirement age, the disability pension payments are reported on lines 5a and 5b of Form 1040 or 1040‐SR.

To determine the portion of Social Security disability payments that are excludable from income, complete the worksheet for Social Security benefits in the instructions to Form 1040 or 1040‐SR. Social Security disability payments are reported on lines 6a and 6b of Form 1040 or 1040‐SR.

Benefit

Accelerated death benefits are an insurance company's payment of some or all of the death benefits under a life insurance policy on account of terminal or chronic illness of the insured. Viatical settlements involve the selling of a cash‐value life insurance policy to a company in the business of buying such policies. Accelerated death benefits and viatical settlement proceeds received by a terminally ill individual are tax free.

Such payments to a person who is chronically ill can be excluded in full to the extent used to pay long‐term care costs; per diem payments in excess of care costs are excludable only up to a set dollar limit per day ($390 in 2022).

Conditions

Tax‐free treatment of accelerated death benefits and viatical settlement proceeds apply for someone who is terminally ill. This means you have a condition or illness that is expected to result in death within 24 months of certification by a physician. The exclusion applies without regard to the use of the benefits or proceeds.

To qualify for favorable treatment as a chronically ill individual, you must be certified by a licensed health‐care practitioner that, within the preceding 12 months, you are unable to perform for a period of at least 90 days 2 or more of the following activities:

• Eating
• Toileting
• Bathing
• Dressing
• Continence
• Transferring (such as getting in and out of bed)

A person also qualifies as chronically ill if certified as requiring substantial supervision for one's own health and safety because of cognitive impairment (for example, the person has Alzheimer's disease).

For a chronically ill individual, excludable amounts must be used to pay long‐term care expenses. These are necessary diagnostic, preventive, therapeutic, curing, treating, mitigation, and rehabilitative services, as well as personal care services. The services must be provided under a plan of care prescribed by a licensed health‐care practitioner (which includes a doctor, registered nurse, or licensed social worker).

Planning Tip

When shopping for life insurance, inquire about accelerated death benefit options under the policy. You want to have as many options as possible, even if you never need to use them.

Pitfall

Generally, it is not advisable for someone who is terminally or chronically ill to use life insurance proceeds to cover lifetime care expenses. The purpose for which the policy was originally purchased, such as the care of surviving family members or the payment of funeral expenses and estate taxes, is frustrated by such use. Thus, using a life insurance policy for lifetime needs is usually a last resort for paying care expenses.

Where to Claim the Benefit

If accelerated death benefits or viatical settlement proceeds are excludable, they are not reported on the return.