Navigating the Aftermath: Understanding Disaster Loss Tax Provisions for Homeowners Affected by Disasters
In recent years, wildfires, hurricanes, and other natural disasters have become increasingly frequent and devastating, leaving many individuals and families grappling with the loss of their homes and personal property. For those affected by such disasters, particularly in areas designated as federal disaster zones, understanding the tax implications and available relief options is crucial. This article delves into the various disaster loss tax provisions, including the limitations, claims process, and tax treatments associated with qualified disaster losses. We will explore the intricacies of claiming losses, the election to claim losses on prior year returns, and the tax implications of insurance payments and FEMA assistance.
Understanding Qualified Disaster Losses - A qualified disaster loss refers to a casualty or theft loss of personal-use property, including a personal residence, attributable to a major disaster declared by the President. These losses are subject to specific provisions that allow taxpayers to claim deductions, even if they do not itemize their deductions. The per-event limitations for qualified disaster losses include an increase in the standard deduction and a waiver of the 10% of adjusted gross income (AGI) reduction, although a $500 per casualty threshold applies.
Specifically, each casualty loss must exceed $500 to be deductible. This threshold is in place to prevent taxpayers from claiming deductions for minor losses, ensuring that only significant losses are eligible for tax relief.
Claiming a Qualified Disaster Loss - The loss can be claimed in the year it occurred or, alternatively, on the prior year's return, which if already filed would have to be amended. This flexibility allows taxpayers to potentially receive a quicker tax refund, providing much-needed financial relief.
However, if there is a reasonable prospect of reimbursement, the deduction is deferred until the reimbursement is determined. If the determination cannot be made by the return due date, then an extension can be filed extending the due date until October 15th. If October 15 falls on a holiday or weekend, the due date is the next business day.
Election to Claim Loss on Prior Year Amended Return - Taxpayers can elect to claim their disaster loss on the prior year's return, and if that return has already been filed, filing it can be amended to claim the disaster loss. This election must be made within six months after the due date of the taxpayer's federal income tax return for the disaster year, without regard to extensions. The election statement should include details of the disaster, the location of the damaged property, and the amount of the loss.
Claiming a disaster loss in the prior year can provide several benefits:
Quicker Access to Refunds: By claiming the loss on the prior year's tax return, you may receive a tax refund more quickly than if you wait to claim it on the current year's return.
Potential for Greater Tax Benefit: Depending on your income and tax situation, claiming the loss in the prior year might result in a larger tax benefit. This is because the tax rates or your income level might have been different, potentially leading to a greater reduction in taxable income.
Flexibility in Tax Planning: Electing to claim the loss in the prior year gives you the flexibility to choose the year that provides the most advantageous tax outcome.
Net Operating Loss Deduction - A disaster loss Net Operating Loss (NOL) is created when a taxpayer's allowable disaster-related losses exceed their income for the year. These losses are treated as "business" losses for the purpose of computing NOLs. When a disaster loss occurs, taxpayers in the affected area may be eligible to claim these losses as NOLs. This allows them to potentially offset taxable income in other years, by carrying the loss forward to future tax years.
For those familiar with NOLs, at one time an NOL could be carried back some years and then forward. However, per current law NOLs can only be carried forward until used up.
Insurance Coverage and Reimbursement - Insurance coverage plays a critical role in disaster recovery. Proceeds from insurance claims must be considered when calculating the deductible loss. If insurance reimbursement is received for living expenses, it is generally not taxable unless it exceeds the actual expenses incurred.
Taxation of FEMA Assistance Payments - FEMA assistance payments are typically not taxable. These payments are intended to help cover essential needs and expenses not covered by insurance. However, any payments received for expenses that are later reimbursed by insurance must be reported as income.
To apply for FEMA assistance after suffering a disaster loss, you can follow these steps:
File a Claim with Your Insurance: Before applying for FEMA assistance, you must file a claim with your insurance company. FEMA cannot duplicate benefits for losses covered by insurance.
Apply for FEMA Assistance: There are three ways to apply:
o Online: Visit DisasterAssistance.gov to apply online. This is the easiest and fastest method if you have internet access and power.
o FEMA App: Use the FEMA App on your mobile device to apply.
o Phone: Call the FEMA Helpline at 1-800-621-3362. The helpline is available every day from 4 a.m. to 10 p.m. Pacific Standard Time. Assistance is available in most languages. If you use a relay service, provide FEMA with the number for that service.
For more information on the types of assistance available, you can visit fema.gov/assistance/individual/program. There is also an accessible video on how to apply available on YouTube titled "FEMA Accessible: Registering for Individual Assistance".
When Disaster Losses Might Result in a Gain - In some cases, insurance proceeds may exceed the adjusted basis of the destroyed property, resulting in a gain. Taxpayers can defer this gain by purchasing replacement property within a specified period, under the involuntary conversion rules of Section 1033.
Involuntary Conversions – IRC Section 1033 allows taxpayers to defer gains from involuntary conversions, such as those resulting from insurance proceeds exceeding the property's basis. To qualify, replacement property must be purchased within a specified timeframe.
This provision helps taxpayers avoid immediate tax liabilities that could arise from such conversions, allowing them to maintain their financial stability while replacing their lost or damaged property.
The general rule under Section 1033 is that taxpayers have two years (four in the case of a disaster) after the close of the first tax year in which any part of the gain is realized to reinvest in similar or related property.
Debris Removal and Demolition Expenses - Debris removal and demolition expenses are generally not deductible in the year of a disaster loss. The treatment of these expenses depends on their nature:
Demolition Expenses: The costs of demolishing structures are typically not deductible. Instead, these costs are charged to the capital account of the underlying land.
Debris Removal Expenses: If the debris removal costs are related to the replacement of part of the property that was damaged, these costs are capitalized and added to the taxpayer's basis in the property.
Filing Extensions – When the President declares a disaster the IRS also provides filing and payment relief for individuals and businesses within the disaster area. These dates are different for each disaster and provided online at the IRS website. As an example, the following are the extended due dates for the 2025 Los Angeles wildfires.
The Internal Revenue Service announced tax relief for individuals and businesses in southern California affected by wildfires and straight-line winds that began on Jan. 7, 2025. No ¶
The tax relief postpones various tax filing and payment deadlines that occurred from Jan. 7, 2025, through Oct. 15, 2025 (postponement period). As a result, affected individuals and businesses will have until Oct. 15, 2025, to file returns and pay any taxes that were originally due during this period.
This means, for example, that the Oct. 15, 2025, deadline will now apply to:
Individual income tax returns and payments normally due on April 15, 2025.
2024 contributions to IRAs and health savings accounts for eligible taxpayers.
2024 quarterly estimated income tax payments normally due on Jan. 15, 2025, and 2025 estimated tax payments normally due on April 15, June 16 and Sept. 15, 2025.
Quarterly payroll and excise tax returns normally due on Jan. 31, April 30 and July 31, 2025.
Calendar-year partnership and S corporation returns normally due on March 17, 2025.
Calendar-year corporation and fiduciary returns and payments normally due on April 15, 2025.
Calendar-year tax-exempt organization returns normally due on May 15, 2025.
In addition, penalties for failing to make payroll and excise tax deposits due on or after Jan. 7, 2025, and before Jan. 22, 2025, will be abated if the deposits are made by Jan. 22, 2025.
The IRS automatically provides filing and penalty relief to any taxpayer with an IRS address of record located in the disaster area. These taxpayers do not need to contact the agency to get this relief.
It is possible an affected taxpayer may not have an IRS address of record located in the disaster area, for example, because they moved to the disaster area after filing their return. In these kinds of unique circumstances, the affected taxpayer could receive a late filing or late payment penalty notice from the IRS for the postponement period. The taxpayer should call the number on the notice to have the penalty abated.
In addition, the IRS will work with any taxpayer who lives outside the disaster area but whose records necessary to meet a deadline occurring during the postponement period are in the affected area. Taxpayers qualifying for relief who live outside the disaster area need to contact the IRS at 866-562-5227. This also includes workers assisting the relief activities who are affiliated with a recognized government or philanthropic organization.
Using Retirement Funds for Recovery – Recent tax legislation includes a provision that allows taxpayers to withdraw up to $22,000 from their retirement funds in the case of federally declared disasters. This provision is designed to provide financial relief to individuals affected by such disasters. The withdrawal:
Is not subject to the usual 10% early withdrawal penalty that typically applies to distributions taken before the age of 59½,
amount can be included in income over a three-year period, and
allows taxpayers to repay the distribution to their retirement account within three years to avoid taxation on the withdrawn amount.
Proving Losses - To substantiate a casualty loss, taxpayers must provide documentation such as photographs, receipts, and insurance claims. Accurate records are essential for claiming deductions and defending against potential audits. The IRS provides several safe harbor methods for calculating disaster losses, including:
Estimated Repair Cost Safe Harbor Method for losses of $20,000 or less - To determine the decrease in the FMV of the personal-use residential real property, the lesser of two repair estimates prepared by two separate and independent contractors, licensed or registered in accordance with state or local regulations, may be used, provided the costs to restore the residence to pre-casualty condition are itemized. Costs that improve or increase the value of the residence above pre-disaster value must be excluded from the estimate. This safe harbor only applies if the loss is $20,000 or less before applying the per-disaster and, when applicable, percentage of AGI reductions.
De Minimis Safe Harbor Method for losses of $5,000 or less - Under the de minimis method, the cost of repairs required to restore the residence to pre-disaster condition may be estimated by the taxpayer. Costs that improve or increase the value of the residence above pre-disaster value must be excluded from the estimate. The estimate must be done in good faith, and the individual must maintain records detailing the methodology used for estimating the loss. This safe harbor only applies if the loss is $5,000 or less before applying the per-disaster and, if applicable, percentage of AGI reductions.
Insurance Safe Harbor Method for losses covered by insurance - The estimated loss determined in reports prepared by the individual’s homeowners’ or flood insurance company may be used.
Contractor Safe Harbor Method based on contractor estimates - The contract price for the repairs specified in a contract prepared by an independent and licensed contractor (or one registered in accordance with state or local regulations) may be used if the contract itemizes the costs to restore the residence to the condition existing prior to the disaster. Costs that improve or increase the value of the residence above pre-disaster value must be excluded from the contract price for purposes of this safe harbor. To use the Contractor Safe Harbor Method, the contract must be a binding contract signed by the individual and the contractor.
Disaster Loan Appraisal Safe Harbor Method based on loan appraisals - Under this method, to determine the decrease in FMV of the individual’s residence, an appraisal prepared for the purpose of obtaining a loan of Federal funds or a loan guarantee from the Federal Government may be used. The appraisal should include the estimated loss the individual sustained because of the damage to or destruction of their residence from the Federally declared disaster.
For personal belongings, the IRS offers:
De Minimis Safe Harbor Method for losses of $5,000 or less.
Replacement Cost Safe Harbor Method for federally declared disasters. This method may be used to determine FMV of most personal belongings located in a disaster area immediately before the disaster to compute the disaster loss. If used, this method must be applied to all eligible personal belongings for which a disaster loss is claimed. This method may not be used for the following: boats, aircraft, mobile homes, trailers, vehicles, and antiques or other assets that maintain or increase in value over time.
# of Years Owned
Percentage of Replacement Cost to Use
1
90%
2
80%
3
70%
4
60%
5
50%
6
40%
7
30%
8
20%
9+
10%
Under this method, first determine the current cost to replace the personal belonging with a new one and reduce that amount by 10% for each year the personal belonging was owned, using the percentages in the adjacent Personal Belongings Valuation Table. A personal belonging owned by the individual for nine or more years, will have a pre-disaster FMV of 10% of the current replacement cost.
Home Destroyed - When a home is destroyed in a casualty or disaster the outcome can be quite different than expected by taxpayers. The reason being that their loss is measured from the lesser of the home’s adjusted basis or the fair market value (FMV) at the time of the loss.
The term "basis" refers to the monetary value used to measure a gain or loss on an asset. A property’s basis is not always equal to the original purchase cost and can be adjusted based on various factors such as improvements, depreciation, and casualty losses. There are also different types of basis, including cost basis, adjusted basis, gift basis, and inherited basis, each with specific rules for calculation depending on the circumstances of how the asset was acquired.
Since real property generally appreciates in value, for tax purposes a home that’s destroyed will generally result in a casualty gain as opposed to a casualty loss once insurance payment is considered. However, the gain can be excluded under the home gain exclusion (IRC Sec 121) if the taxpayer(s) qualifies and any remaining gain (up to the basis of a replacement home acquired) can be deferred under the involuntary conversion rules discussed previously. In the case of a disaster loss, that replacement period endsfour years after the close of the first tax year in which any part of the gain is realized.
The Section 121 home gain exclusion refers to the ability of taxpayers to exclude up to $250,000 of capital gains from the sale of their primary residence if they are single, or up to $500,000 if they are married and filing jointly. To qualify, the taxpayer must have owned and used the home as their principal residence for at least two of the five years preceding the sale. This exclusion can generally be used once every two years. There are exceptions and special rules, such as those related to involuntary conversions, expatriates, and depreciation recapture for business use of the home.
This is all best explained by example:
Example – A wildfire in a disaster area destroys Phil’s home which had an adjusted basis of $125,000. Phil is single and has owned and used the home for over 10 years before it was destroyed. Phil’s insurance company pays Phil $400,000 for the house. A tax loss is different from a financial loss in that a tax loss is measured from the lesser of the home’s adjusted basis or the FMV at the time of the loss. So, in this case Phil does not have a tax loss, he has a gain.
The destruction of Phil’s home is treated as a sale for tax purposes and since Phil meets the 2 out of 5 years ownership and use tests, the Sec 121 gain exclusion will apply. In addition, any gain more than the amount excluded can be deferred under Sec 1033. Here is how it all plays out for Phil…
Insurance company payment $400,000
Phil’s adjusted basis in the home <125,000>
Realized Gain 275,000
Sec 121 Gain Exclusion <250,000>*
Remaining Gain 25,000
Phil elects to defer gain into replacement <25,000>**
Net taxable gain 0
* Since the disaster was treated as a sale, presumably Phil would be qualified for another $250,000 Sec 121 exclusion after owning and using the replacement property for two years.
** Per Sec 1033 deferral, this amount reduces the basis of Phil’s replacement home. This is an election, and Phil could instead choose to pay the tax on the gain instead of deferring it. In addition, the deferral cannot reduce the basis of the replacement property below zero; thus, any amount not deferred would be taxable.
Casualties on Business Property and Inventory Losses - Although this article is primarily devoted to homeowner disaster losses, some homeowners may also own a business within the disaster area:
business property, casualty losses are deductible against business income. Inventory losses due to a disaster can be claimed as a deduction, reducing both income and self-employment taxes.
Losses from Investment Property - Losses from investment property are treated similarly to personal-use property losses. However, the deduction is limited to the lesser of the decrease in fair market value or the adjusted basis of the property.
Navigating the aftermath of a wildfire and the associated tax implications can be overwhelming. However, understanding the available disaster loss provisions and tax treatments can provide significant financial relief. By leveraging these provisions, affected individuals can mitigate the financial impact of their losses and begin the process of rebuilding their lives. It is advisable to consult with this office to ensure all available options are utilized and compliance with IRS regulations is maintained.
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