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Tax aspects of casualty gains and losses.

A series of recent natural disasters, including Hurricane Andrew which hit Miami and the surrounding area on August 24, 1992, has made it necessary for an unprecedented number of taxpayers and their advisors to become familiar with the tax consequences of casualty gains and losses (not to mention building codes, insurance and mortgage provisions). My interest is first-hand, as my own home suffered substantial damage by Hurricane Andrew.

All main tax considerations relating to involuntary conversions are discussed below with special emphasis on examples of personal casualties relating to homes and personal use property. For obvious reasons, hurricane damage is used for illustrative purposes.

Limitations on Personal Casualty Loss Deductions

Casualty losses are deductible under Section 165(a). However, the deduction for losses of money or property not connected with a trade or business or a transaction entered into for profit ("personal casualty losses") are subject to four special limitations:

1. The deduction is only allowable to taxpayers who itemize expenses as opposed to taxpayers who claim the standard deduction. The standard deduction was $5,700 on a joint return in 1991, $6,000 in 1992 and $6,200 in 1993.

2. In the case of a total loss of property, the amount of the loss is limited to the lesser of the fair market value of the property immediately prior to the loss or its adjusted basis under Reg. 1.165-7(b)(1)(i). The loss is, of course, reduced by insurance proceeds received.

3. Each casualty loss (total losses from the same casualty, as opposed to each item damaged or lost) must be reduced by $100 under Section 165(h)(1).

4. Casualty losses after the application of the above limitations are deductible only to the extent they exceed 10% of a taxpayer's adjusted gross income under Section 165(h)(2)(A).

Example: Taxpayer's house was completely destroyed by a hurricane. Immediately before the casualty, the house had an adjusted basis of $100,000 and a fair market value of $80,000. Insurance proceeds of $60,000 were received. If the house was the taxpayer's residence and the taxpayer's adjusted gross income (AGI) was $40,000, the casualty loss deduction is computed as follows:

* The lesser of adjusted basis or fair market value is $80,000.

* $80,000 less insurance proceeds equals $20,000.

* $20,000 is reduced by $100 to $19,900.

* $19,900 is reduced by $4,000 (10% of AGI) to $15,900, which is deductible on Schedule A as an itemized expense.

If the house was rented out or used for business purposes, the deduction would simply equal adjusted basis of $100,000 less insurance proceeds of $60,000 or $40,000. The deduction would be claimed on the appropriate form, e.g., Schedule E for rental property or Schedule C for self-employed individuals who use the building in their business.

It should be noted that in the case of a personal casualty, no deduction is possible if insurance proceeds equal the fair market value of the property as reduced by $100 and 10% of AGI.

Personal Use Property

Because of the severe limitations on the amount deductible as personal casualty losses, it is important to be aware of which items constitute personal property. Examples include:

* Personal residences, such as the principal residence, vacation homes, hunting lodges, etc.;

* Private automobiles, boats and aircrafts;

* Home furnishings, carpeting and appliances;

* Jewelry, antiques, art works, books, stamps and other collectibles held for personal purposes.

In addition, the damaged or destroyed property must actually belong to the taxpayer, the taxpayer's spouse (if a joint return is filed) or to the taxpayer's dependents. The casualty loss is increased by debris removal and cleanup expenses.

Reduction in Value Approach

Although not technically required, appraisals, photographs and physical evidence will make it more likely that a casualty loss deduction will withstand possible IRS challenges. Thus, appraisals before and after the casualty that establish the decline in the fair market value of the property due to the casualty are one way to compute the amount of the casualty loss (before limitations). Obtaining an appraisal of a damaged house is obviously easier than an after-the-fact appraisal of the home as it was before the disaster. However, an estimate may be made by real estate professionals based on sales prices of comparable properties just before the loss. For autos, "Blue Book" values may be used to establish pre-loss values; for household furniture and other personal property, a detailed inventory showing original costs and estimates of fair market values and replacement costs are desirable.

The cost of professional appraisals, photographs, videotaping, etc., are not deductible as casualty losses. However, such expenses constitute "miscellaneous itemized deductions," the sum of which are deductible to the extent they exceed 2% of AGI.

Repair Cost Approach

As an alternative to proving the decline in fair market value of property partially destroyed, taxpayer may elect to use the cost of restoration to original condition. The IRS requires the following information under Reg. 1.165-7(a)(2)(ii).

* The repairs are necessary to restore the property to its pre-casualty condition.

* The amount expended is not excessive.

* Repairs performed are limited to the damage sustained.

* The property's value after the repairs have been made does not exceed the property's pre-casualty value.

"Repairs v. Decline in Value" Election

Since a taxpayer has a choice between deducting actual repair costs required to restore the property or the decline in value caused by the casualty prior to repairs, the greater amount should clearly be claimed. However, it should be kept in mind that it is easier to prove repair costs (with receipts and canceled checks) than a decline in value, since the latter is more subjective.

Example: A homeowner's house was partially destroyed by a hurricane. Competent appraisals show a decline in fair market value from $100,000 to $60,000. If repair costs only amount to $15,000--for example, because the taxpayer does much of the work himself or has friends and/or relatives in the construction business--the $40,000 decline in value (less limitations) should be deducted. The value decline cannot exceed the adjusted basis in the house, however, as previously stated. It should be noted that regardless of how the casualty loss is computed, the loss deduction available for tax purposes reduces the adjusted basis in the property with respect to which it is claimed under Section 1016.

General Market Declines

When a casualty results in a decline in values of both damaged and undamaged properties, Reg. 1.165-7(a)(2)(i) requires that before and after appraisals take this phenomenon into account.

Example: A taxpayer's home was damaged by a hurricane and was worth $300,000 before and $200,000 after the storm. However, if the home would have been worth only $240,000 after the hurricane, even if undamaged, the casualty deduction is limited to $40,000. This frequently happens because of a flight from hurricane-prone areas, depressed market prices, destruction of businesses and public attractions in the area, etc.

Since the computations are made immediately after the disaster, it is irrelevant that the market value may eventually recover to the former level. This limitation may make the election to use the cost of repairs and restoration more attractive.

Insurance Claims and Settlements

Personal casualty losses covered by insurance are not deductible unless an insurance claim has been filed under Section 16-(h)(4)(E). However, if the loss exceeds insurance proceeds, a deduction is allowed subject to the limitations discussed above.

Expenses incurred in reaching a settlement with the insurer may include lawyer's fees, accountant fees, fees of umpires, arbitrators or mediators, etc. Such fees are not deductible as casualty losses. Rather, they reduce the insurance proceeds recovered.

Insurance proceeds that have a reasonable likelihood of being collected reduce the amount of casualty losses that can be claimed. It follows that:

* No casualty loss deduction is allowed if it is expected that a full insurance recovery will be made.

* A casualty loss can be claimed in the year sustained for the previous year in a disaster area (even though insurance proceeds are pending) as long as the casualty loss exceeds the expected coverage. Coverage is expected if a lawsuit is filed.

* An additional casualty loss may result in a subsequent year if insurance proceeds actually collected (if any) fall short of the expected amount assumed in the loss year.

A taxpayer may deduct a casualty loss unreduced by insurance--in good faith--even after filing an insurance claim, believing that a recovery is highly unlikely. If an insurance payment is unexpectedly made in a subsequent taxable year, such amount constitutes gross income in the year received under the tax benefit rule in Section 111. An amended return is not required. The amount received is gross income only to the extent of the casualty deduction actually claimed unless the amount is so substantial as to also generate a casualty gain.

It is also possible that a casualty gain was originally reported but is increased by a higher-than-expected insurance payment. An amended return should then be filed. Finally, it is possible that a casualty gain was reported but that the insurance payment turned out to be smaller than assumed. Again, an amended return should be filed to reduce the casualty gain retroactively or even to claim a casualty loss.

Casualty Losses as Net Operating Losses

Even personal casualty loss deductions in excess of taxable income result in net operating losses under Section 172(d)(4)(C). As a result, such excess losses may be carried back three years and forward up to 15 years under Section 172(b)(1)(A).

Example: A taxpayer sustained a deductible $30,000 casualty loss from hurricane damage in 1992. If the taxpayer's taxable income was $18,000, the excess $12,000 may be carried back to 1989, 1990 and 1991, then to 1993, etc. If the taxpayer lived in an area declared a Disaster Area, the deduction may be claimed for 1991 by election with any excess carried back to 1988, 1989 and 1990, then to 1992, etc.

A taxpayer who expects to be in a higher tax bracket the year(s) after the year of loss may wish to elect to forego the carryback under Section 172(b)(3).

Cash Gifts

Many disaster victims receive cash gifts from friends, relatives and neighbors or from emergency disaster funds set up gratuitously by their employers. The IRS takes the following positions:

* Amounts received are excluded from gross income as gifts under Section 102.

* The casualty loss deduction, if any, does not have to be reduced by the amounts received unless "the money received must be used by the recipient to rehabilitate or replace the property which is the subject of the claimed casualty deduction."

Example: An employee suffers a casualty loss of $40,000 to her home, $28,000 of which is deductible for tax purposes. If the employee receives $15,000 tax-free from her employer's emergency fund without limitations or directives relating to how the money is to be used, she still can claim a casualty loss of $28,000. If the money is required to be used to repair and restore the house, the casualty loss deduction is reduced to $13,000.

The Unitary Approach to Personal Residences

A personal residence includes the building and the land, including trees, plants and shrubs. As a result, a homeowner does not have to allocate adjusted basis and fair market values to the various items of realty comprising a home.

Example: A homeowner created an impressive garden from scratch at a nominal out-of-pocket cost, which over the years developed into an attractive collection of ornamental, fruit- and nut-bearing trees. Although the house suffered minimal damage, the garden was totally destroyed by a hurricane, resulting in a reduction in value of the overall property of $20,000 plus $5,000 (Rev. Rul. 131, 1953-2 CB 112 and Rev. Rul. 64-3-9, 1964-2 CB 58) in debris removal cost. The casualty loss deduction is $25,000 before limitations.

It should be noted that gain or loss must be computed separately for personal property in the residence, such as furniture, appliances and glassware.

Casualty Gains in a Principal Residence

A homeowner's adjusted basis in the home itself is often lower than expected due to two factors:

1. Because of the two-year rollover of gain rules in Section 1034, an older homeowner's adjusted basis in a residence may be little more than the cost of the first home ever purchased, five homes ago, since deferred gains reduce the adjusted basis in the replacement home.

Example: A homeowner purchased a first home for $10,000. Many years later it was sold for $100,000, whereupon a new home was purchased for $105,000. The adjusted basis in the new home is $15,000 ($105,000 less $90,000 of realized gain deferred).

2. From the purchase price of the property must be subtracted the cost of the land, furnishings, appliances, curtains, rugs and other personal property, to arrive at the adjusted basis of the house itself.

Total Destruction

If a homeowner suffers a complete loss of a principal residence and collects insurance proceeds in excess of the adjusted basis in the house, such excess is gross income. However, under Section 165(h)(2)(B) a net personal casualty gain for a given year is a capital gain. If the home was held over one year, the gain is a long-term capital gain. Furthermore, if the taxpayer's long-term capital gains for the year exceed short-term losses, the excess is a "net capital gain" subject to a maximum tax rate of 28% under Section 1(h).

The homeowner may, however, defer the gain by investing the insurance proceeds in another home or rebuilding. It should be noted that the mandatory two-year rollover of a home provision in Section 1034 does not apply to involuntary conversions (casualties) under Reg. 1.1033(a)-3. Rather, a taxpayer who wishes to defer the casualty gain must elect to do so under Section 1033. On the other hand, in lieu of the rigid two-year rule in Section 1034, the taxpayer has the rest of the taxable year of the casualty plus two more years plus possible extensions to replace the home without recognizing gain. If less than all insurance proceeds are reinvested, a capital gain results to the extent of the extra funds retained.

Example: A taxpayer purchased a home for $100,000, $20,000 of which was reasonably allocable to the land. Several years later, the home was completely destroyed in a hurricane on January 2, 1993, when the home was worth $300,000, of which $50,000 represented the value of the land. The insurer paid $250,000 for the value of the house and the taxpayer promptly sold the land for $50,000. The taxpayer realized a gain of $170,000 on the house ($250,000 less $80,000) and $30,000 on the land, for a total of $200,000.

Since the casualty necessitated the sale of the land, the full gain of $200,000 is realized from an involuntary conversion and is a casualty gain. The taxpayer has until the end of 1995 (plus possible extensions) to acquire another home. If the new home costs $300,000 or more, no gain is recognized and the adjusted basis in it equals its cost, less $200,000 of deferred gain. If the new home costs less than $300,000--e.g., $230,000--$70,000 of capital gain is recognized and the new home's basis equals $100,000 ($230,000 less $130,000 of deferred gain).

If the home was seized, requisitioned or condemned, however, and the homeowner received a condemnation award in excess of basis, the homeowner may elect to fall under the two-year rollover of a residence provision rather than the involuntary conversion provision pursuant to Section 1034(i). Possible advantages of making the election include:

* If the taxpayer happened to have purchased another home within two years prior to the casualty, it may be treated as the replacement residence even though there was no contemplation of an involuntary conversion. An example is the case where a taxpayer moved into a new home and had not yet sold the old one but rented it out with an option to buy.

* Under Section 1034(b), the "adjusted sales price" which must be reinvested to defer all gain is reduced by "fixing-up expenses" not otherwise deductible or added to basis.

* Members of the armed forces may extend the two-year replacement period by up to two more years under Section 1034(h).

The $125,000 exclusion

Under Section 121, a homeowner over age 55 has a once-in-a-lifetime election to exclude up to $125,000 of gain from the sale or exchange of a principal residence. Under 121(d)(4), the election may be made with respect to a gain from an involuntary conversion as well. Thus, a homeowner over age 55 who has not made the election previously and who does not plan to buy another home should make the Section 121 election. It is made on Form 2119, "Sale of Your Home," the same form used for the two-year rollover provision. The homeowner must have owned the home for at least three of the last five years and have used it as a principal residence at least three of the last five years prior to the conversion, but not necessarily concurrently. If the insurance proceeds result in a realized gain in excess of $125,000, the remaining gain may be deferred by reinvesting the insurance proceeds (less $125,000) in related property, e.g., improvements within the "two-year-plus" replacement period under Reg. 1.121-5(B).

Mortgage Insurance

Due to a depressed real estate market, many homeowners who put up a small down payment have a "negative equity" in their homes (the mortgage loan balance exceeds the value of the home). If such a home is destroyed in a hurricane or other disaster, the lender (mortgagee) collects the mortgage balance from its insurer and the ex-homeowner deeds the land to the insurance company.

Example: A homeowner purchased a home for $100,000, $20,000 of which allocable to the land. At a time when the property was worth $80,000 and the mortgage balance was $90,000, the home was totally destroyed by a hurricane. The insurer paid off the $90,000 mortgage and the ex-homeowner deeded the land to the insurer. No casualty deduction is allowed since the taxpayer was relieved of a mortgage in excess of fair market value. The taxpayer has sustained a loss of $10,000 ($100,000 less $90,000). However, this is a personal loss, nondeductible under Section 262, not a casualty loss. If the value of the home was in excess of the mortgage, a casualty loss would be possible.

In most cases, even Hurricane Andrew caused only partial damage to a residence. Even in situations where the insured received a flat sum from the insurer that proved more than sufficient to repair or replace a roof, walls or ceilings, casualty gains only result if the insurance proceeds exceed the total basis in the home. Any amount left over merely reduces the homeowner's adjusted basis in the home. In other words, in the absence of a realized gain there can be no recognized gain, even if the homeowner is enriched!

Example: The homeowners have an adjusted basis of $100,000 in their home, which suffers substantial damage during a hurricane. They receive $75,000 from their insurer for the damage to the real property. They spend $40,000 on capital improvements (e.g., replacing the roof and rebuilding a wall), $10,000 on repairs (e.g., indoor and outdoor painting, new wallpaper, etc.), and invest the remaining $20,000 in the stock market.

The homeowners do not realize a gain since the insurance proceeds of $75,000 did not exceed their $100,000 basis. However, the amount not spent on capital improvements--$35,000--reduces their adjusted basis in the home to $65,000. No reporting requirements exist (see below).

Casualty Gain on a Home Followed by Resale

In some cases, a taxpayer who sustains substantial damage to a home may collect insurance proceeds in excess of the home's adjusted basis and then decide to sell the home either "as is" or after making minimal repairs to make it more saleable. If the home is repairable, this approach results in two separate transactions for tax purposes. However, if the home must be razed, the sale is a direct and mandatory result of the involuntary conversion, so only one transaction has occurred.

Example 1: A homeowner's house with an adjusted basis of $90,000 was so badly damaged by a hurricane as to unrepairable. The insurance company paid $150,000 for the damage, whereupon the homeowner sold the property for $50,000. For tax purposes, the homeowner has received the full $200,000 on account of an involuntary conversion and has realized a $110,000 gain from an involuntary conversion. The homeowner has the usual "two-year-plus" to reinvest in another home to defer the gain. However, if the homeowner is over age 55, an election may be made under Section 121 to simply exclude the gain since it does not exceed $125,000.

Example 2: Same as Example 1 except the home is repairable. In this case, the homeowner first realizes a gain of $60,000 from the involuntary conversion. At the time of sale, another $50,000 of gain is realized in a separate transaction (sale of a home). The full $50,000 is gain because the homeowner recovered the basis in the home plus $60,000 from the insurer and thus had a zero basis at the time of sale.

To fully defer the two gains, the total $200,000 received must be reinvested. Technically, $150,000 must be reinvested within the "two-years-plus" period mandated by Section 1033 (the involuntary conversion section) and $50,000 within the "two-years-after-closing" period mandated by Section 1034 (the replacement of a principal residence section). As a practical matter, a new house must be purchased by the earlier of the two replacement periods.

This scenario poses a problem for taxpayers over age 55, since the Section 121 election to exclude gain may only be applied to one disposition of a home. Thus, the homeowner in this example may elect to include the $60,000 gain or the $50,000 gain but not both. This makes a replacement, even a temporary one, more attractive for tax purposes.

Casualty Gains on Personal Property

Since personal property is nondepreciable, the adjusted bases in furniture and household goods equal their original cost. However, if the insurance policy provides for replacement value, gains on numerous items may result, particularly with respect to jewelry, art works and collectibles. Technically, gain or loss must be computed on each item or at least classes of items (the stamp collection, the wardrobe). To defer gain, the Section 1033 election must be made for each identifiable item or category of items. Any cash left over is taxable as a capital gain to the extent of realized gain.

Example: A taxpayer's piano, purchased for $7,000, was destroyed and the insurance company paid $15,000. A new piano was purchased for $13,000. The taxpayer's realized gain equaled $8,000 ($15,000 less $7,000). The taxable gain (recognized gain) equals $2,000 (the cash left over). The cost basis in the new piano equals $7,000, the carryover basis of $7,000, less "boot" of $2,000 and plus $2,000 of gain recognized.

If the taxpayer has both casualty gains and losses from the same casualty, the gains and losses (not reduced by $100) are netted. A casualty gain taxed as a capital gain only results to the extent gains exceed losses. If losses exceed gains, a net casualty loss results, deductible subject to the $100 and 10% of AGI limitations described above.

Temporary Living Expenses

When a home becomes uninhabitable because of a casualty involving extensive damage, lack of utilities, etc., the homeowner with family may incur temporary living expenses such as hotel bills or short-term rent. Such living expenses, like all personal expenses, are nondeductible under Section 262. However, insurance coverage for temporary living expenses is usually part tax-free under Section 123. The exclusion is limited to expenses actually incurred in excess of normal living expenses saved (expenses that would have been incurred during the relevant time period but were not).

Example: After a hurricane, a taxpayer and family moved into a hotel for 30 days at a cost of $4,000 plus $1,000 for meals. If the insurance company paid $4,200 and normal living expenses would have been $1,500, the exclusion is $3,500 ($5,000 less $1,500). As a result, the taxpayer must report $700 of gross income ($4,200 less $3,500).

It should be noted that fixed costs, such as mortgage payments, property taxes and minimum phone charges, are payable even if the homeowner is absent and these costs are not part of normal living expenses. As a result, the exclusion tends to be a large portion of insurance proceeds.

Disaster Areas

If the president of the U.S. declares a Disaster Area under the Disaster Relief and Emergency Act, taxpayers may elect to claim a casualty loss resulting from the disaster in the previous taxable year under Section 16-(i). If a return has already been filed for the previous year, an amended return should be filed if necessary, e.g., Form 1040X. Possible advantages of making this election include:

* A refund check is available within weeks.

* Interest is paid on the refund.

* If the taxpayer's AGI was lower the previous year, the deduction is higher due to the 10% floor. Disadvantages of the election may include:

* An amended return may have to be filed.

* The taxpayer may not have the information required to compute the loss, e.g., the insurance company has not yet processed the claim.

* AGI for the previous year may be higher than for the current year.

Example: A taxpayer's home was destroyed by Hurricane Andrew on August 24, 1992. The estimated loss is $15,000 after insurance proceeds and the $100 deductible. AGI on the 1991 tax return, filed in April, was $50,000 and is estimated to be $40,000 for 1992. The taxpayer thus has a choice between filing an amended return for 1991 claiming a deduction of $10,000 ($15,000 less 10% of $50,000) and get a quick refund or waiting until 1993 and claiming a deduction of $11,000 ($15,000 less 10% of $40,000).

In cases where immediate cash flow is not a concern, a taxpayer may be advised to wait until 1993, when AGI for both 1991 and 1992 are known, before making the election. However, the election to claim the loss in the prior year must be made by the due date of the loss year (without extensions), e.g., by April 15, 1993.

"Miscellaneous Itemized Deductions"

Casualty losses are excluded from the definition of "miscellaneous itemized deductions" under Section 67(b)(3), presumably because of the number of other limitations placed on personal casualty losses.

Phase-Out of Itemized Expenses

Casualty losses are excluded from the definition of "itemized deductions" subject to an up to 80% phase-out for high income taxpayers under Section 68(c)(3), again because of the other limitations applicable.

Alternative Minimum Tax

Casualty losses are deductible in computing alternative minimum taxable income under Section 56(b) to the same extent that they are deductible for regular income tax purposes.

Emergency Loan Interest

After a disaster, a number of low-income, uninsured or under-insured homeowners receive Federal loans on favorable terms--for example, from the Small Business Administration or the Federal Emergency Management Agency (FEMA). Receiving such a loan to repair, rebuild or reconstruct a residence has no impact on the casualty loss deduction. Furthermore, the interest on the loan is deductible as long as the loan qualifies under Section 163(h)(3)(C) as "home equity indebtedness," i.e., it can not exceed $100,000 and must be secured by a "qualified residence." However, such interest is not deductible for alternative minimum tax purposes, since Section 56(e)(1) requires that the loan was used to acquire, construct or substantially improve a residence, not merely to repair it.

Special Rules for Business/Investment Casualties

The main differences in the tax treatment of business casualty losses are as follows:

* In the case of total destruction of business property, the adjusted basis is deductible even if the fair market value is less.

* The casualty loss is not reduced by $100 or by 10% of AGI.

* An insurance claim is not a prerequisite to claiming a deduction.

* Each item of property damaged must be handled individually even if part of a whole, e.g., trees and buildings.

In cases where property is used partly for business and partly for personal purposes--e.g., the taxpayer lives on the first floor and rents out the second--the property is treated as two separate assets, one of which is subject to personal casualty loss rules, the other to the business casualty loss rules.

IRS Reporting Requirements

The following duties apply with respect to reporting to the IRS.

Insurance companies have no duties to report insurance proceeds paid to any taxpayers to the IRS, regardless of the amount.

Taxpayers who receive insurance proceeds, regardless of amount, have no duty to report the receipt of such funds if no gain is realized. Thus, where insurance proceeds received on account of a damaged home do not exceed its adjusted basis, the IRS need not be notified. This is true even if a homeowner has substantial sums left over after completing repairs. However, taxpayers should keep track of amounts not spent on capital improvements so they will be able to compute the reduced basis in the home in case of a later sale or disposition.

If insurance proceeds with respect to property exceed its basis, a realized gain results. A taxpayer who does not intend to replace or restore the property will, of course, have to recognize the gain in the return for the year during which proceeds are received.

If the taxpayer intends to reinvest the insurance proceeds in similar property within two years after year-end, thus deferring the gain, the election to do so is deemed made even if the taxpayer does nothing, i.e., does not report a gain "even though the details in connection with the conversion are not reported ... under Reg. 1.1033(a)-2(c)(2). The same regulation, however, states somewhat inconsistently that when a gain results from an involuntary conversion, "All of the details ... shall be reported ..." in the return for the year the gain is realized.

A taxpayer who winds up with a previously unreported gain when the replacement period expires due to the failure to reinvest all insurance proceeds must report the gain in an amended return for the year the insurance proceeds were received.

When an election to defer a gain is made or deemed made, "all the details" regarding any reinvestment must be provided with the returns for the years involved.

It should be noted that the three-year statute of limitations does not start with respect to a gain from an involuntary conversion until the IRS has received notice of replacement, intention to replace or failure to replace under Reg. 1.1033(a)-2(c)(5). Thus, if a taxpayer reports nothing, the statute never starts even if a return is filed with respect to the gain realized from the involuntary conversion.

IRS Forms and Publications

IRS Publication 584, Casualty Loss Workbook, explains how to identify damaged property and compute casualty losses.

IRS Form 4684, Casualties and Thefts, is required to be filed if a casualty loss is claimed. Instructions accompanying the form illustrate how to compute casualty gains and losses from personal as well as business properties. Although no substantiation is required to be filed with the return, taxpayers must be prepared to present proof of loss if audited.

Conclusion

A taxpayer who is a victim of a natural disaster may have a casualty gain or loss for tax purposes, depending on factors such as insurance coverage, the relationship between basis and value of affected properties and whether the loss is a personal or a business loss. Casualty gains are easily deferred by election if the property is to be replaced. However, personal casualty losses are subject to severe limitations. The key to a successful deduction is adequate proof of loss, such as appraisals, repair costs, photographs and good records.

Rolf Auster, PhD, LLM, is professor of taxation in the School of Accounting at Florida International University in Miami. He holds a PhD in finance from Northwestern University, an LLM in Taxation and is a CPA and Certified Financial Planner.
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Author:Auster, Rolf
Publication:The National Public Accountant
Date:May 1, 1993
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