Casualty losses may be tax deductible Tax Matters by David A. Katzman If you or someone you know was the victim of a major personal loss, the Internal Revenue Service (IRS) may be able to offer a bit of a silver lining. The IRS allows victims of fires, storms, other acts of nature, theft, accidents or “sudden, unexpected or unusual” events to take a casualty loss deduction. However, there are several restrictions. First, your deduction is limited to compensation for the physical damage or loss of your personal property—not losses incurred because of damage to another person’s property or physical injuries. For example, if you are financially responsible for a car accident, the damages paid to another party are not deductible. Likewise, if you are physically injured and incur medical expenses, you cannot take a casualty loss deduction. However, you may qualify for a medical deduction. When you claim a casualty loss it is dependent on the type of loss. For losses from a natural disaster, you generally claim the deduction during the year the loss occurred. If your loss is part of a federally declared disaster area, however, you have two possible options. You may take a deduction during the year of the event or during the year before it occurred. This second option could increase your tax savings, depending on your taxable income for both years. Claiming the deduction earlier also helps speed up the receipt of a possible tax refund. In the even of a theft, you may take a deduction during the year when the theft is discovered. The amount you may deduct must be calculated based on the lesser of the drop in property value or your “basis,” which is the amount you actually paid for the property. Establishing value can be difficult. The original receipt, if you have it, will establish your basis. However, establishing pre- and post-disaster value may require appraisals or other documentation. Here is how it works once value is established. If you paid $1,000 for a painting and it subsequently appreciated to $5,000, but was damaged in a fire and is now worth $2,000, your tax deduction is just $1,000. Your basis is $1,000 and the drop in value is $3,000, so you must use the lesser of the two amounts. Your actual casualty loss tax deduction must also be reduced by the amount of any reimbursement you receive from insurance proceedings. Even if you fail to file a claim, you cannot take a deduction if you were entitled to an insurance reimbursement. You must also reduce your total deduction by a one-time amount for each event. For 2008, that amount is $100, for 2009 it is $500. There are some specifically designated events that are not subject to this reduction. For example, Hurricanes Katrina, Rita and Wilma are exempt. Finally, you must reduce the amount of your deductible losses by 10 percent of your adjusted gross income (AGI). For example, if your losses total $10,000 and your AGI is $60,000, then 10 percent is $6,000, so your casualty deduction would be $4,000. For high-income taxpayers, this final qualifying factor often eliminates or greatly reduces the amount of any casualty loss deduction. However, if your loss occurred in 2008 and 2009 and was a federally declared disaster, it is exempt from this 10-percent reduction requirement. If you did not itemize for 2008 or 2009, you can take an additional standard deduction for net losses incurred from federally declared disasters. This applies for both regular tax obligations and alternative minimum tax (AMT) obligations. For tax purposes, there is also a casualty gain, although any related taxes may usually be avoided or deferred. A gain occurs when the amount you receive from your insurance coverage exceeds your basis. For example, if the home you purchased 10 years ago for $150,000 is destroyed and you receive $300,000 from your insurance company, you have a casualty gain of $150,000 for tax purposes. As you can see, claiming a casualty loss can be complicated. If you have such a loss, a tax professional can help you determine the amount you may deduct from your federal income taxes. David A. Katzman is a certified public accountant licensed to practice in the State of Florida and the Commonwealth of Massachusetts. He is also a certified financial planner and certified senior advisor. Please consult your tax advisor for details and assistance in applying this general information to your specific situation.