New refund opportunities for prior casualty and theft losses.

Changes made by the Tax and Trade Relief Extension Act of 1998, the Internal Revenue Service Restructuring and Reform Act of 1998 and Taxpayer Relief Act of 1997 may trigger refund opportunities for casualty and theft deductions taken or limited in prior open years. This article explains all of these legislative amendments and offers examples.

Taxpayers incurring casualty or theft losses in the current or a previous tax year may have new opportunities to maximize the tax benefits resulting therefrom. Substantial changes to these provisions were made by the Tax and Trade Relief Extension Act of 1998 (TTREA '98), the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA '98) and the Taxpayer Relief Act of 1997 (TRA '97); however, official guidance was not released until the 1999 tax season was well under way.(1) Thus, tax advisers may have overlooked certain provisions and been unaware of retroactive effective dates. Accordingly, any previously filed tax return containing a casualty or theft loss, for which the statute of limitations remains open, should be examined for possible application of these changes.

While the TTREA '98 contained numerous technical corrections (discussed below) that affect a wide range of taxpayers, the TRA '97 contained only two major provisions affecting casualty and theft losses. First, under TRA '97 Section 1082(b), amending Sec. 172(b)(1)(F), any part of a net operating loss (NOL) arising from a casualty or theft occurring after Aug. 5, 1997, was made eligible for a three-year carryback period.(2) Second, under TRA '97 Section 915, if an individual located in an area Presidentially declared a disaster after 1996 was granted an extension to file under Sec. 6081 and to pay under Sec. 6161, the Service will abate, for the extension period, any interest assessed under Sec. 6601. IRSRRA '98 Section 3309, amending Sec. 6404(h), broadened this interest abatement to other taxpayers and to Presidentially declared disaster areas in years after 1997.

These provisions are a complex web. This article attempts to unravel the recent statutory changes to the casualty and theft loss provisions made by the TTREA '98, IRSRRA '98 and TRA '97, and proffer tax savings opportunities.

General Provisions

To fully comprehend the effect of the technical amendments, an examination of the statutory provisions is required. Sec. 165(a) allows a deduction for losses sustained during the tax year not compensated for by insurance or otherwise; for individuals, Sec. 165(c)(1)-(3) limits the deduction to:

1. Losses incurred in a trade or business.

2. Losses incurred in any transaction entered into for profit, though not connected with a trade or business.

3. Except as provided in Sec. 165(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.

Thus, Sec. 165(c)(1) and (2) generally allow a deduction for a variety of losses in the trade or business and for-profit transaction contexts. However, deduction of losses on personal-use property is restricted to the events noted in #3 above. Exhibit 1 on p. 184 summarizes the general treatment of casualty and theft losses.

Exhibit 1: Casualty and Theft Loss Deduction Summary

Type                                Code

Incurred in a trade or business     Sec. 165(c)(1)

Incurred in a transaction entered   Sec. 165(c)(2)
into for profit (rent or royalty
property)

Incurred in a transaction entered   Sec. 165(c)(2)
into for profit (property other
than rent or royalty property)

Incurred on employee property       Sec. 67(a)

Incurred on personal-use property   Sec. 165(c)(3)

Type                                Deduction restrictions/
                                    limits

Incurred in a trade or business     Deductible for AGI

Incurred in a transaction entered   Deductible for AGI
into for profit (rent or royalty
property)

Incurred in a transaction entered   Deductible from AGI as a
into for profit (property other     miscellaneous itemized
than rent or royalty property)      deduction

Incurred on employee property       Deductible from AGI as
                                    miscellaneous itemized
                                    deduction subject to the
                                    2% floor

Incurred on personal-use property   Deductible from AGI, subject
                                    to $100 and 10% of AGI limits

Type                                Examples

Incurred in a trade or business     Depreciable personal and
                                    real property

Incurred in a transaction entered   Lease or rental property
into for profit (rent or royalty
property)

Incurred in a transaction entered   Stocks, notes, bonds, gold,
into for profit (property other     silver, works of art,
than rent or royalty property)      improved land

Incurred on employee property       Computer required as condition
                                    of employment

Incurred on personal-use property   Automobile, jewelry, principal
                                    residence

Prior to its amendment by the Deficit Reduction Act of 1984 (DRA '84) Section 711(c)(2)(A)(i), Sec. 165(c)(3) referred to casualty and theft losses on both personal and income-producing property. After the DRA '84, it referred only to personal casualty and theft losses. This distinction is the basis for many of the clarifications made by the TTREA '98.

TTREA '98 Technical Corrections

The TTREA '98 made various changes to the casualty and theft loss provisions. Among these were changes to: Sec. 67(b)(3) (2% floor on miscellaneous itemized deductions); Sec. 68(c)(3) (3%/80% reduction in itemized deductions); Sec. 172(d)(4)(C) (NOLs); and Sec. 873(b)(1) (deductions by nonresident aliens). These provisions, together with Sec. 56(b)(1)(A)(i) (alternative minimum taxable (AMT) income adjustments), which refers to Sec. 67(b), had in common a pre-TTREA '98 reference to Sec. 165(c)(3).

Rather than changing Sec. 165(c)(3), the TTREA '98 rectified the DRA '84's unintended results by amending the various Code provisions that refer to Sec. 165(c)(3). As discussed below, all of these technical corrections are taxpayer-friendly and have retroactive effective dates; thus, tax advisers should assess their clients' refund opportunities, if applicable.

2% Floor on Miscellaneous Itemized Deductions

Pre-TTREA '98, Sec. 165(c)(3) losses were excluded from the list of Sec. 67(a) miscellaneous itemized deductions subject to the 2% AGI floor. TTREA '98 Section 4004(b)(1) clarified that Sec. 165(c)(2) casualty and theft losses sustained on income-producing property are also excluded, effective for tax years beginning after 1986.

Example 1: S sustained a $10,000 casualty loss to income-producing property in 1997. Her 1997 AGI was $100,000; she had no other miscellaneous itemized deductions subject to the 2% floor: Prior to the TTREA '98, S's casualty loss deduction was $8,000 ($10,000 - $2,000 floor). After the TTREA '98, S's deduction is $10,000; accordingly, she can file an amended return to recover the additional taxes paid on her 1997 return.

This correction is also important in the AMT context; Sec. 67(a) miscellaneous itemized deductions are excluded from the computation of the Sec. 56(d)(2)(A)(i) and (b)(1)(A)(i) AMT-NOL.

3%/80% Reduction in Itemized Deductions

Sec. 68(c)(3) identifies exclusions from itemized deductions for purposes of the Sec. 68(a) 3%/80% reduction in itemized deductions. Pre-TTREA '98, Sec. 165(c)(3) losses were so excluded. TTREA '98 Section 4004(b)(2) amended Sec. 68(c)(3) to also exclude Sec. 165(c)(2) losses from the list, effective for tax years beginning after 1990. Thus, Sec. 165(c)(2) deductions are no longer subject to the 3%/80% reduction in itemized deductions.

Example 2: R and N filed jointly in 1997, with $750,000 of AGI and the following itemized deductions: $4,000 in real estate taxes, $8,500 in state income taxes, $7,500 in charitable contributions and a $20,000 casualty loss on income-producing property. Their pre- and post-TTREA '98 itemized deductions are as follows:

Pre-TTREA '98:

1. Potential reduction = ($750,000 - $121,200 threshold) x 0.03 = $18,864

2. Maximum reduction in itemized deductions = $40,000 x 0.8 = $32,000

3. Reduction is lesser of $18,864 or $32,000

4. R's and N's itemized deductions are $21,136 ($40,000 - $18,864)

Post-TTREA '98:

1. Potential reduction = ($750,000 - $121,200 threshold) x 0.03 = $18,864

2. Maximum reduction in itemized deductions = $20,000 x 0.8 = $16,000

3. Reduction is lesser of $18,684 or $16,000

4. R's and N's itemized deductions are $24,000 ($40,000 - $16,000)

In the above example, R and N have an additional $2,864 in itemized deductions after the TTREA '98. Thus, the legislation (1) decreased the 3%/80% reduction by excluding the casualty loss deduction from the calculation and (2) permitted a full casualty loss deduction.

Taxpayers with lower AGI may also benefit from this law change, depending on the amount and composition of their itemized deductions in relation to their AGI.

Example 3: K and L filed jointly in 1997, with $400,000 of AGI and the following itemized deductions: $8,000 in state income taxes and a $20,000 casualty loss on income-producing property. Their pre-and post-TTREA '98 itemized deductions are as follows:

Pre-TTREA '98:

1. Potential reduction = ($400,000 - $121,200 threshold) x 0.03 = $8,364

2. Maximum reduction in itemized deductions = $28,000 x 0.8 = $22,400

3. Reduction is lesser of $8,364 or $22,400

4. K's and L's itemized deductions are $19,636 ($28,000 - $8,364)

Post-TTREA '98:

1. Potential reduction = $400,000 - $121,200 threshold) x 0.03 = $8,364

2. Maximum reduction in itemized deductions = $8,000 x 0.8 = $6,400

3. Reduction is lesser of $8,364 or $6,400

4. K's and L's itemized deductions are $21,600 ($28,000 - $6,400)

After the TTREA '98, K and L are entitled to an additional $1,964 deduction.

NOLs

In computing an individual's NOL, Sec. 172(d)(4) provides that nonbusiness deductions are allowed only to the extent of related nonbusiness gross income. Pre-TTREA '98, Sec. 172(d)(4) limited an NOL deduction for a casualty loss on income-producing property to gross income on the property. TTREA '98 Section 4004(a) amended Sec. 174(d)(4)(C) to add the Sec. 165(c)(2) deduction to the nonbusiness casualty and theft loss deductions that, for an individual, are treated as attributable to his trade or business. Thus, all deductions for nonbusiness casualty and theft losses are taken into account in computing an NOL. This change is effective for tax years beginning after 1983.

Example 4: C and D filed jointly in 1997, with $35,000 in wages and a $60,000 casualty loss on income-producing property. Their pre-TTREA '98 NOL was calculated as follows:

Wages                             $35,000
Casualty loss                     (60,000)
Standard deduction                 (6,900)
Exemptions
 (2 X $2,650)                      (5,300)

Taxable income                   $(37,200)

NOL computation:
Add back nonbusiness
 deductions:
Casualty loss          $60,000
Standard deduction       6,900
Exemptions               5,300   $ 72,200

NOL                                   -0-

In this case, the casualty loss cannot create an NOL, because it is deemed nonbusiness in nature. Post-TTREA '98, the casualty loss is treated as attributable to a trade or business, altering the result as follows:

Taxable income                  $(37,200)

NOL computation:
Add back nonbusiness
 deductions:
Standard deduction     $6,900
Exemptions              5,300     12,200

NOL                             $(25,000)

Nonresident Alien Deductions

Finally, TTREA '98 Section 4004(b)(3) modified Sec. 873(b)(1) to allow nonresident aliens deductions for casualty and theft losses' on income-producing property located in the U.S., effective for tax years beginning after 1983. Previously, such losses were allowed only if such property was "effectively connected" with the conduct of a U.S. trade or business.

Example 5: O, a nonresident alien, owns rental property in Key West, Florida that suffered considerable damage in a 1997 hurricane. Before the TTREA '98, this property was not classified as effectively connected income-producing property or as personal-use property that would trigger a casualty and theft loss. The amount and type of deduction, if any, was in doubt. After the TTREA '98, O is assured a deduction, despite the fact that the property is not "effectively connected."

TRA '97 and IRSRRA '98 Changes

NOLs

TRA '97 Section 1082(a) amended Sec. 172(b)(1)(A) generally to provide that NOLs in tax years beginning after Aug. 5, 1997, may be carried back two years and forward 20. TRA '97 Section 1082(b) retained a three-year carryback period under Sec. 172(b)(1)(F) for "eligible losses" defined by Sec. 172(b)(1)(F)(ii) as:

1. In the case of an individual, losses of property arising from fire, storm, shipwreck or other casualty, or from theft.

2. In the case of a small business, NOLs attributable to Presidentially declared disasters (as defined in Sec. 1033(h)(3)).

3. In the case of a taxpayer engaged in the trade or business of farming (as defined in Sec. 263A(e)(4)), NOLs attributable to such Presidentially declared disasters.(3)

TTREA '98 Section 4003(h) added Sec. 172(b)(1)(F)(iv) to coordinate ordinary and eligible losses. Ordinary losses with a two-year carryback period are used first; eligible losses with a three-year carryback period are used next. This rule is likewise effective for tax years beginning after Aug. 5, 1997.

Example 6: N's taxable income was $200,000 in each of 1997, 1998 and 1999. In 2000, she suffers a $120,000 NOL in her business and $350,000 in damages from an earthquake in a Presidentially declared disaster area. Under Sec. 172(b)(1)(F), N would first offset the $120,000 ordinary NOL against her 1998 taxable income, reducing it to $80,000. Next, of the $350,000 eligible casualty loss, $200,000 would be carried back to 1997, reducing her 1997 taxable income to zero. Of the remaining $150,000 ($350,000 - $200,000), $80,000 would be offset against her remaining $80,000 of 1998 taxable income; the $70,000 ($150,000 - $80,000) balance would be offset against $70,000 of her 1999 income.

Interest Abatement

TRA '97 Section 915 provided that, if an individual located in a Presidentially declared disaster area is granted an extension to file Federal income tax returns under Sec. 6081 and to pay Federal income tax under Sec. 6161, the Service will abate, for the extension period, any interest assessed under Sec. 6601. IRSRRA '98 Section 3309 amended Sec. 6404(h) to provide that, if any taxpayer located in a Presidentially declared disaster area is granted an extension to file under Sec. 6081 and to pay under Sec. 6161, the Service will abate, for the extension period, any interest assessed under Sec. 6001. Thus, the IRSRRA '98 extended interest abatement relief to entities other than individuals (e.g., trusts, estates and corporations).

Notice 99-2(4) explained that TRA '97 Section 915 applied only to disasters declared during 1997, and that Sec. 6404(h) applies to disasters declared after 1997, but only for tax years beginning after 1997. To clarify the confusion, TTREA '98 Section 4003(e) redefined "Presidentially declared disaster area" to include disasters declared in either 1997 or 1998. The IRS acknowledged in Notice 99-2 that some individuals may have been incorrectly assessed interest on returns for tax years beginning before 1998, if they were located in areas the President determined in 1998 to be disaster areas. The Service indicated an intention to identify such taxpayers and make the appropriate adjustments by the end of 1999; nonetheless, tax advisers may file Form 843, Claim for Refund and Request for Abatement, or call IRS Customer Service (at [phone]) to request an interest abatement.

Conclusion

The casualty and theft loss provisions, and related ancillary computations, have undergone a succession of taxpayer-friendly changes via 1997 and 1998 legislation; such changes may well have been overlooked by tax professionals. Although official guidance on these changes was not released until 1999, the effective dates, as summarized in Exhibit 2 on p. 186, vary considerably As a result, many practitioners may find it advisable to examine for refund opportunities every return filed during the past two years containing a casualty or theft loss deduction.

Exhibit 2: Legislative Changes and Effective Dates

Area                                     Change

NOL computation                          Casualty or theft losses
(Sec. 172(d)(4)(C))                      on income-producing
                                         property are attributable
                                         trade or business

NOL carryover period                     Casualty or theft portion
(Sec. 172(b)(1)(F)(ii)(I))               of NOL may be carried back
                                         three years

2% floor on miscellaneous itemized       Does not apply to casualty
deductions (Sec. 67(b)(3))               or theft losses on income
                                         -producing property

3%/80% reduction in miscellaneous        Does not apply to casualty
itemized deductions (Sec. 68(c)(3))      or theft losses on income
                                         -producing property

Deduction by nonresident aliens          Allowed for casualty or
(Sec. 873(b)(1))                         theft loss on income
                                         -producing property
                                         located in U.S.

Interest abatement on extended returns   Interest abated on
(Sec. 6404(h))                           extended returns for
                                         length of extension

Area                                     Enacted by

NOL computation                          TTREA '98 Section 4004(a)
(Sec. 172(d)(4)(C))

NOL carryover period                     TRA '97 Section 1082(b)
(Sec. 172(b)(1)(F)(ii)(I))

2% floor on miscellaneous itemized       TTREA '98 Section
deductions (Sec. 67(b)(3))               4004(b)(1)

3%/80% reduction in miscellaneous        TTREA '98 Section
itemized deductions (Sec. 68(c)(3))      4004(b)(2)

Deduction by nonresident aliens          TTREA '98 Section
(Sec. 873(b)(1))                         4004(b)(3)

Interest abatement on extended returns   TRA '97 Section 915;
(Sec. 6404(h))                           IRSRRA '98 Section 3309

Area                                     Effective for tax years
                                         beginning after

NOL computation                          1983
(Sec. 172(d)(4)(C))

NOL carryover period                     Aug. 5, 1997
(Sec. 172(b)(1)(F)(ii)(I))

2% floor on miscellaneous itemized       1986
deductions (Sec. 67(b)(3))

3%/80% reduction in miscellaneous        1990
itemized deductions (Sec. 68(c)(3))

Deduction by nonresident aliens          1983
(Sec. 873(b)(1))

Interest abatement on extended returns   1997
(Sec. 6404(h))

EXECUTIVE SUMMARY

* The casualty and theft loss provisions (and related ancillary computations) have undergone a succession of taxpayer-friendly legislative changes.

* Although the law changes were enacted a while ago, interpretive guidance was released only relatively recently.

* Some of the amendments are retroactively effective to 1984.

(1) For example, the February 1999 revisions of IRS Pubs. 547, "Casualties, Disasters, and Thefts (Business and Nonbusiness)," and 584, "Casualty, Disaster, and Theft Loss Workbook (Personal-Use Property)," were released in April 1999. Notice 99-2, IRB 1999-2, 8, discussing interest abatement on extensions filed from disaster areas (effective for tax years beginning after 1997), was released in January 1999.

(2) Under TRA '97 Section 1082(b), the carryback period under Sec. 172(b)(1)(F)(ii)(II) for small business NOLs occurring after Aug. 5, 1997, attributable to Presidentially declared disaster areas, was also extended from two years to three years.

(3) TTREA '98 Section 2013(c) added flush language to Sec. 172(b)(1)(F)(ii) to provide that an eligible loss does not include any farming loss, to which a five-year carryback applies.

(4) Notice 99-2, note 1 supra.

Nell Adkins, Ph.D., CPA Assistant Professor Department of Accounting and Information Systems University of Alabama at Birmingham Birmingham, AL

Frank Messina, DBA, CPA Associate Professor Department of Accounting and Information Systems University of Alabama at Birmingham Birmingham, AL

Steven C. Thompson, Ph.D., CPA Professor Department of Accounting, Tax and Business Law College of Business Florida Gulf Coast University Fort Myers, FL