Dealing with the tax consequences of a natural disaster.
The Internal Revenue Service showed some compassion for affected taxpayers when it responded to Hurricane Hugo and the San Francisco earthquake. Hugo struck Charleston, South Carolina, on September 21, 1989, and the earthquake hit San Francisco one month later. Each left thousands of buildings, businesses and residences damaged or destroyed. Utilities and phone service were lost for more than a week.
As a result, many law and accounting firms were closed for days or weeks while debris was cleared and power and telephone service restored. From a tax standpoint, this business interruption was very inconvenient because only 25 days remained to file 1988 extended individual tax returns when Hugo struck. The IRS softened the blow for victims of both disasters by granting relief in IRS notice 89-136 for late filing of extended individual returns, late payroll tax returns and deposits and late business and estate tax returns.
Future concessions are very possible for tax returns and deposits that may be due soon after a catastrophe, but taxpayers in other disaster areas are not guaranteed a waiver of penalties and definitely will not have interest waived if filing and payment deadlines occur soon after a disaster.
DEALING WITH PERSONAL GAINS
Any of number of IRC sections can apply to disaster losses and gains. The key factor in determining the proper tax treatment is the essential character of the gain or loss. (Exhibit 1 on page 53 gives a brief summary of the most relevant sections.)
Special rules are provided for taxpayers in disaster areas. The foremost rule is that losses are reduced to the extent insurance or other reimbursements will offset them. This is true even though a taxpayer suffers a loss in one tax year and does not receive insurance proceeds until the next or succeeding tax year. Many taxpayers suffering losses in the fall of 1989 were not reimbursed until 1990. However, insurance reimbursements not yet received were charged against 1989 losses.
Losses on personal use property, called personal casualty losses, are subject to several limitations. First, the losses stemming from a casualty or involuntary conversion of personal assets are reduced by $100. All losses resulting from a single casualty can be combined prior to the $100 deduction.
Second, the losses are matched against personal casualty gains. If the result is a net loss, the loss is an allowable deduction to the extent that it exceeds 10% of adjusted gross income (AGI). If the result is a net gain, the gain is treated as a capital gain.
Personal casualty losses are allowable deductions in computing alternative minimum taxable (AMT) income. When matching personal casualty gains and losses results in a net gain, the personal casualty losses are fully deductible in computing AGI for purposes of the AMT.
For example, assume a taxpayer has a personal casualty loss of $30,000 and a personal casualty gain of $50,000. AGI before casualty gains and losses is $40,000. The personal casualty loss is reduced by $100, to $29,900. This amount is fully deductible in computing AGI and offsets $29,900 of personal casualty gains. The excess personal casualty gain of $20,100 ($50,000 minus $29,900) is treated for tax purposes as a gain from the sale of a capital asset.
If, on the other hand, the personal casualty loss is $50,000 and the personal casualty gain is $30,000, the loss is reduced by $100, to $49,900 and the first $30,000 of loss offsets the gains. AGI remains at $40,000. Thus, 10% of AGI is $4,000. To the extent the remainder of the loss, $19,900 ($49,900 less $30,000), exceeds $4,000, that amount (in this case, $15,900) is allowable as an itemized deduction to the individual taxpayer. For the AMT, the taxpayer must recompute AGI under AMT income principles before applying the 10% limit.
Unfortunately, Congress did not make clear whether the passive loss rules apply to casualty losses incurred by taxpayers. The American Institute of CPAs identified this problem and potential inequity in letters to Congress and the IRS. The IRS responded by amending temporary regulation section 1.469-2T to exclude casualty losses andcasualty loss reimbursements from passive activity loss rules. Also, it issued notice 90-21, which states that all of the property used or created by a passive activity must be lost in a casualty for he loss to be considered a complete disposition of the property.
ELECTING THE PROPER YEAR
TO CLAIM LOSSES
IRC section 165(i) allows disaster losses to be deducted either in the year the loss is sustained or in the preceding tax year. The election must be made by the time the tax return for the year of the loss is filed. For example, taxpayers sustaining a loss from Hugo had the option of either filing an amended 1988 return claiming the loss or waiting to claim it on the 1989 tax return. This option offers significant tax benefits to individual and business taxpayers alike, since they are likely to have less revenue and greater expenses in the year the disaster strikes. However, both tax years need to be assessed carefully before making the election.
HANDLING DAMAGE CLAIMS
FOR PERSONAL RESIDENCES
Perhaps the greatest number of losses in the recent disasters involved personal residences. Thousands of homes were completely destroyed and millions of others required extensive repairs, leaving the former residents temporarily homeless. There are several determinations tax consultants in disaster areas should make in considering whether to claim gains or losses on damaged residenced.
Determination of the loss. The taxpayer must prove the amount of any personal casualty loss, including a damaged building. The determination of a property loss sounds simple but the rules and regulations can make it difficult. The fair market value of the property before the disaster must be compared with its fair market value after the disaster; the difference is the amount of the loss suffered by the taxpayer. Unfortunately, very few taxpayers have had an appraisal or fair market value determination made of their property immediately before a disaster.
An appraisal performed immediately after the casualty will provide proof of the value of the property at that time but it is also necessary to verify the decline in fair market value. The courts have accepted the costs involved in restoring the property to its original condition as indicative of the decline in property value. However, no matter how costly the restoration may be, the casualty loss is limited to the taxpayer's cost basis.
Taypayers must then determine whether they have one or several assets. If a taxpayer purchases a home for $100,000, there is a question about whether that cost should be apportioned among the land, its landscaping and the structure. If so, then a separate before and after fair market value determination would be needed for each asset. On the other hand, the $100,000 may be considered the cost of a single property and the determination of its before and after value is made as a unit. Any resulting loss is limited to the cost basis of the entire property.
For nonbusiness property, Treasury regulations and various court cases have held that a home and its surrounding landscaping should be treated as one property. Accordingly, the loss is calculated by determining the property's value before and after the casualty but is limited to the cost basis of the entire property. However, this does not apply to assets used in a trade or business or held for profit. In those cases, costs must be allocated and fair market value determined for each asset on the property. The IRS has accepted the replacement cost of ornamental trees and shrubs as evidence of the decrease in value for purposes of the casualty loss determination.
Deductibility of interest. When taxpayers borrow money to repair personal residences, the interest on unsecured loans is personal interest, notwithstanding IRC section 163, which permits a deduction for qualified residential interest--interest on a loan secured by a personal residence. Qualified residential loans can be obtained only on acquisition or substantial improvement of a residence or through a home equity loan. Home equity loans can't exceed $100,000 and must be secured by the taxpayer's personal residence. Thus, when possible, taxpayers who need to borrow large sums to repair their homes should consider refinancing an existing mortgage or obtaining a home equity loan so the interest will be deductible.
However, after a severe catastrophe, it may be difficult for a taxpayer to acquire a home equity loan because the debt secured by the residence exceeds its reduced fair market value. Qualifying home equity loans cannot exceed the fair market value of the home less the original acquisition indebtedness. Therefore, tax advisers need to be cautious when counseling clients about borrowing to repair.
Acquisition indebtedness may create tax deductible interest on repair of a home destroyed by a casualty. The IRC defines acquisition indebtedness as any debt used in acquiring, constructing or substantially improving any qualified residence of the taxpayer. The aggregate amount may not exceed $1 million. Thus, if the improvements to the qualified residence were substantial, an individual could create tax deductible interest by taking a secured loan against a damaged home to repair it.
There is no clear definition of a substantial improvement to a residence. According to private letter ruling no. 8548027, substantial implies an addition, such as the construction of a new room, as opposed to a mere repair, such as replacing a roof. However, common sense suggests a home destroyed to any significant degree would be substantially improved with repair.
Deferral of gains. An individual whose home is destroyed and who receives insurance may realize a gain if the insurance proceeds exceed the cost basis of the home. If the proceeds of insurance (proceeds from the disposition of the personal residence) giving rise to the gain are reinvested in another personal residence within two years of the date of the sale of the old property, no gain will be realized by the taxpayer, according to IRC section 1034. Taxpayers, however, may elect to fall within section 1033, which permits a taxpayer to replace property that has been converted involuntarily as long as the replacement or substantial repair occurs by the end of the second taxable year following the year in which the loss is realized. So, individual taxpayers whose personal residences are destroyed and who have gains from insurance have two ways to avoid taxation on the gain.
Taxpayers over 55 years of age have an additional way to defer any gain on personal residences resulting from a disaster. IRC section 121 allows these taxpayers to exclude up to $125,000 of gain on the sale of a principal residence. A conversion of a principal residence to cash (insurance proceeds) following a disaster may be construed as a sale. The $125,000 exclusion, a one-time election, should be considered carefully before it is used.
Loss of use of personal residence. Many taxpayers in disaster areas are compensated for the loss of use of personal residences and apartments. The IRS has ruled that any compensation exceeding additional living costs will be considered ordinary income to the taxpayer. Accordingly, taxpayers should maintain detailed records of their living expenses while their homes are being repaired.
Condemnations and rehabilitation credit. Advisers to taxpayers whose personal residences are condemned as a result of a disaster should review IRC section 165(k), which makes special provision for deduction of losses from demolition or relocation of residences after a disaster. Additionally, some taxpayers may qualify for certain rehabilitation credits if their property is considered historic.
DEALING WITH BUSINESS GAINS
Some of the tax consequences of disaster losses for businesses are similar to those for individuals but many are not. For instance, both individuals and businesses may deduct all losses stemming from property used in a trade or business, even though passive activity rules may affect the deduction's timing.
Many assets can be classified as capital assets, generally defined as those that are neither inventory nor depreciable property used in a trade or business. Depreciable assets and land used in a trade or business that have been held over one year are covered under IRC section 1231. Practitioners should keep in mind that section 1231 rules are very complex and require careful review. Particular attention should be paid to the way in which the interplay between section 1231 and sections 1245 and 1250 can affect section 1231 gains. A loss of such assets is allowable to the extent of capital gains, unless it is suspended by the passive activity rules. The net loss is limited to $3,000 in any one tax year but the capital loss can be carried forward indefinitely. For corporations, the losses are only allowable to the extent of gains and the loss can be carried forward only for five years.
Companies that receive business interruption insurance settlements should treat them in the same manner as the lost profits they were designed to replace. A company operating on a cash basis would treat the settlement as gross receipts in the period received. For an accrual basis taxpayer, the amounts would be accrued as soon as the right to receive the insurance settlement was negotiated.
AFTER A DISASTER
All inventories affected in a disaster should be analyzed to assess the tax consequences. Inventory destroyed by a casualty is written off through the normal process of determining the yearend inventory. In other words, inventory assets destroyed by the disaster will be expensed by being added to cost of sales or cost of goods sold.
There may be some confusion about the treatment of proceeds from insurance for inventory destroyed by the disaster. The proceeds normally are included in income as sales from the disposition of the destroyed inventory.
Any gain on the involuntary conversion of inventory can be avoided through the election of section 1033. The taxpayer needs only to acquire replacement property similar to the property involuntarily converted by the end of the second taxable year following the taxable year in which the involuntary conversion occurred. Thus, if insurance proceeds create a gain on the destruction of inventory, the resulting gain can be deferred until the replacement inventory is sold.
Inventory losses incurred in a casualty cannot be deferred. They must be recognized in the year of loss. The allowable loss is the excess of the cost of the destroyed inventory over the insurance proceeds received for the destruction of inventory.
Treasury regulation 1.471-2(c) deals with the valuation of damaged inventory and applies to taxpayers who use the cost method or the lower of cost or market method of inventory valuation. It requires the taxpayer to offer the damaged goods for sale at the claimed lower value within 30 days after the end of the year in which the loss was sustained. The taxpayer must have detailed records supporting such an offering to substantiate the loss in value and allow a deduction of the excess of the damaged inventory's cost over its value. Records of goods actually sold at lower prices would provide the taxpayer with additional proof needed to sustain or write down damaged inventory.
When inventory is damaged, a gift, rather than a sale, might be appropriate. Normally the contribution of inventory to a qualified charitable organization does not result in a deduction in excess of the cost basis of the inventory given. However, IRC section 170(e)(3) contains an exception for contributions to organizations that use the donated property solely for the ] care of the ill, the needy or infants.
The deduction is limited to the cost basis of the inventory plus one-half of the difference between the basis and the donated goods' fair market value. The charitable organization must give the donor a written statement saying the use of the inventory property is related to the reason for the charity's tax exemption.
THE EFFECT OF DISASTERS
Many business owners caught in a disaster overlook the impact of the damage on future depreciation of assets. For example, if a taxpayer bought a building and placed it in service in 1982, the taxpayer would have been depreciating that building over an 18-year life. If a 1989 disaster destroyed half of the building, the taxpayer would be entitled to deduct half of the remaining undepreciated cost to the extent it was not reimbursed by insurance.
However, if the reinvestment of insurance proceeds creates a new cost basis, a new depreciable asset is formed. Whenever a new cost basis is applied to assets converted through disasters, the new depreciation rules--modified accelerated cost recovery system--also will apply. Such assets consequently will be depreciated over much longer periods than assets acquired before the Tax Reform Act of 1986.
Furthermore, any assets involuntarily converted will result in investment tax credit recapture to the extent the credit has not been re-earned. No investment credit will be allowed on the new cost basis. Assets under repair are subject to the uniform capitalization cost rules provided by IRC section 263A. Consequently, interest and other overhead associated with repair may need to be capitalized.
Advisers should keep in mind that the writeoff of depreciable property as a result of a casualty may differ for regular tax and AMT purposes. Similarly, the new depreciation rules that will apply to property replacing destroyed property would be subject to the AMT depreciation rules.
ONLY A BEGINNING
Tax planning following a disaster is a complex endeavor involving many sections of the tax code. While this discussion has highlighted some of the more important issues, it is not comprehensive. However, it may provide a point of reference for the tax planning that will follow future disasters.
ROBERT BALDWIN, CPA, is a sole practitioner in Charleston, South Carolina. He is a member of the American Institute of CPAs tax division and the South Carolina Association of CPAs. LINDA M. PLUNKETT, CPA, PhD, is associate professor of accounting at the College of Charleston, South Carolina. She is a member of the American Accounting Association, the American Woman's Society of CPAs and the South Carolina CPA society. REBECCA B. HERRING, CPA, is associate professor of accounting at the College of Charleston. She is a member of the AICPA, the AAA and the National Association of Accountants. Professors Plunkett and Herring are coauthors, with Francis A. Humphries, of "Let's Make Required CPE Rules Uniform," which appeared in the December 1988 Journal (page 70).
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|Author:||Herring, Rebecca B.|
|Publication:||Journal of Accountancy|
|Date:||Aug 1, 1990|
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