As I sat on my parents’ deck last week, I could see huge plumes of smoke in the distance. The fire in Pender County, NC, where my parents live had reached nearly 30,000 acres (or about 47 square miles) by the time we were headed home. A lack of rain kept fires burning there for more than two weeks putting more than 2,000 homes danger, especially along U.S. 17.
It’s proving to be a tough summer for the folks in North Carolina. In addition to the Pender County fire, there’s another one burning in Dare County. In April, storms hit the middle of the state, killing 22 people and injuring 130. And hurricane season is just getting started.
Of course, North Carolina isn’t the only state with more than its share of tragedy this year. Massive fires are burning in Arizona, Texas, and California. Tornadoes ripped through Missouri and Kansas earlier, setting records for injuries and loss.
The federal government has responded to much of the loss by offering aid to help cover the cost of removing debris and rebuilding in areas hit the hardest. But aid only goes so far. What about those homes and families affected by the storms and fires that won’t receive federal or other aid?
Hopefully, those folks were covered by insurance, though insurance doesn’t always cover the entire scope of the loss. To the extent that taxpayers don’t have insurance, a casualty loss related to a disaster may be available on a federal income tax return.
According to the IRS, a casualty loss is the result of “the damage, destruction or loss of your property from any sudden, unexpected, or unusual event such as a flood, hurricane, tornado, fire, earthquake or even volcanic eruption.”
Interestingly, though, the actual statute isn’t quite as limiting. Internal Revenue Code §165 has as a general rule:
There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.
However, losses for individuals not connected with a business are further limited at Internal Revenue Code §165(c)(3):
[E]xcept as provided in subsection (h), losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft.
That definition has been modified a bit over the years. Interestingly, allowing tax deductions for losses is something that has been allowed for more than 100 years under the Tax Code. Yeah, I know that the Tax Code as we know it isn’t quite 100 years old… But prior attempts at establishing a federal income tax included deductions for property losses.
In 1867, deductions were allowed for losses related to fire and shipwrecks, something that 19th century Americans knew quite a bit about. In 1870, the same year that the Harpers Ferry Flood devastated parts of the Shenandoah, the definition was expanded to include floods though the wording was changed to “storms” a few years later.
That wording stayed consistent under the “modern” tax system created by the 1913 Tax Code. The first tax form under the new system (downloads as a pdf) allowed a general deduction for:
Losses actually sustained during the year incurred in trade or arising from fires, storms, or shipwreck, and not compensated for by insurance or otherwise.
By 1916, the wording included not only natural disasters but “other casualty” and “theft”:
Losses actually sustained during the year, incurred in his business or trade, or arising from fires, storms, shipwreck, or other casualty, and from theft, when such losses are not compensated for by insurance or otherwise
Today, casualty, disaster and theft losses for individuals are lumped together in one category. Losses are no longer restricted to those tied to natural disasters and include financial losses from theft and other crimes. For purposes of the deduction, theft is considered the taking and removing of money or property with the intent to deprive the owner; both elements are key here in that the taking must have been illegal and there must have been criminal intent.
The most infamous case focusing on financial loss was the Madoff case. Most tax professionals thought at the time that the staggering losses from that scheme would fall under the existing casualty/theft loss rules. However, the IRS has noted that, “[t]o have a theft loss, there needs to be some evidence of criminal theft.” Since questions about the scheme existed – as well as the scope – the rules were eased in 2009 for 2008 losses related to the Ponzi scheme (Madoff, by the way, pleaded guilty to all charges).
Another twist proved that under today’s law, you can cause your own damage and perhaps still be eligible to take the deduction. Justin M. Rohrs, a California resident, successfully claimed a casualty loss deduction for his 2006 Ford F-350 pickup truck after he flipped his truck while legally drunk. Rohrs was turned down for reimbursement by his insurer and subsequently turned down by the IRS for the deduction. Rohrs took the IRS to court (representing himself, no less) and won. The IRS relied on Treas. Reg. 1.165-7(a)(3), which states that you can claim a casualty loss for damage to a vehicle only if the damage is not due to the willful act or willful negligence of a taxpayer. The judge, however, found that (opinion downloads as a pdf) “[w]hile petitioner’s decision to drive after drinking was negligent, that alone does not automatically rise to the level of gross negligence.” He therefore allowed the deduction.
Notwithstanding Mr. Rohrs’ success in court, the rules for the deduction can be tricky. It’s best to consult with a tax professional if you have questions about whether you qualify or how to calculate your loss.
Assuming that you qualify for the deduction, to claim casualty and theft losses, you must itemize your deductions. To claim the deduction, report the losses on a federal form 4684, Casualties and Thefts (downloads as a pdf).
As has been the case for years, you may not deduct casualty and theft losses covered or reimbursed by insurance. You must also include any adjustments to your property’s basis in your calculation and you can’t claim a loss greater than the worth of the property.
If your loss deduction is more than your income, you may have a net operating loss. Unlike many other deductions, you do not have to be in a trade or business to have a net operating loss from a casualty.
You usually claim a casualty loss in the year the disaster occurs. However, if the loss is in a federally declared disaster area, you may choose to treat the loss as having occurred in the year immediately preceding the tax year in which the disaster happened; you simply file an amended return.
This is one area of tax law that will continue to change. Crimes are becoming more sophisticated and losses are happening in ways Congress could not have contemplated (identity theft and cybercrimes, for example) even a few years ago. The idea behind the deduction has, of course, always been to try and give taxpayers some relief from the hand they were dealt either from Mother Nature or some other unforeseen circumstances.
A tax deduction is a small consolation, however, for a taxpayer who has lost a home or property in a storm or had their life’s savings raided by an unscrupulous person. Hopefully, this is a deduction that you, as a taxpayer, won’t need any time soon.
Note: The TCJA made changes to the casualty loss deduction.