Read § 165(c)(3), § 165(e), § 165(h), § 165(i).
Losses caused by “fire, storm, shipwreck, or other casualty, or from theft” do not usually result from personal consumption choices. Hence, a deduction seems appropriate. From the beginning, a problem has been to distinguish between a “bad hair day” and the type of damage that represents such a deprivation of consumption choice that a taxpayer should be permitted to share his/her burden with other taxpayers. This has not proved to be an easy line to draw – and one does not have to search the digests very hard to find contradictory results.
Courts have had great difficulty defining “casualty,” and there is no definition in the regulations. Certain considerations seem relevant:
- Not every loss should be treated as resulting from a casualty. We drop a plate, and it breaks. It’s called “life,” not a casualty.
- There are certain risks that we may willingly assume. When something untoward materializes, we are in no position to complain. We own a cat and an expensive vase and put both of them in the same room at the same time. The cat knocks the vase over, and it breaks. SeeDyer v. Commissioner, T.C. Memo. 1961-141, 1961 WL 424 (1961).
- We certainly should not complain when the casualty is the result of our deliberate conduct. The arsonist should not be permitted to claim a casualty loss deduction when he burns down his own house, even though his loss was quite literally caused by “fire.” SeeBlackmun v. Commissioner, 88 T.C. 677, 681 (1987), aff’d, 867 F.2d 605 (1st Cir. 1988) (violation of public policy).
- We engage in a business where a certain amount of breakage is predictable. Taxpayer operates a fleet of taxicabs, and a few of them are damaged in traffic accidents.
- There are risks that we should be expected to address. When damage occurs over a period of time, perhaps taxpayer should be expected to take measures to address the problem. There are many cases involving damage that termites caused, and the results are not entirely consistent.
What clues does the IRS provide in the following revenue ruling to help determine just what is a deductible casualty loss?
Rev. Rul. 76-134
CASUALTY LOSS DUE TO FLOOD DAMAGE
The questions presented are (1) whether losses from damage to property resulting from abnormally high water levels on bodies of water and (2) amounts expended for the construction of protective works or for moving homes back from their original locations to prevent probable losses from future storms are deductible as casualty losses under § 165 of the Internal Revenue Code of 1954.
Section 165(a) of the Code provides the general rule that there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise. Section 165(c) provides, in part, that in the case of an individual, the deduction is limited 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, and (3) losses of property not connected with a trade or business, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. In respect of property not connected with a trade or business, a loss shall be allowed only to the extent that the amount of loss to such individual arising from each casualty, or from each theft, exceeds $100.
Section 263 of the Code provides that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.
Court decisions and revenue rulings have established standards for the application of the above provisions, and have developed the overall concept that the term ‘casualty’ as used in such provisions refers to an identifiable event of a sudden, unexpected, or unusual nature and that damage or loss resulting from progressive deterioration of property through a steadily operating cause would not be a casualty loss. [citations omitted].
Accordingly, losses due to physical damage to property, such as buildings, docks, seawalls, etc., as a result of wave action and wind during a storm are deductible as casualty losses under § 165 of the Code. Similarly, losses due to flooding of buildings and basements as a result of a storm and the complete destruction of buildings, occurring as a result of storm damage, are deductible casualty losses.
However, there are situations in which damage or expenditures may be incurred due to high water on bodies of water that may not be casualty losses under § 165 of the Code such as damage or loss of value due to gradual erosion or inundation occurring at still water levels. The term ‘still water levels’ as used herein means normal seasonal variations in the water level of a body of water.
These variations are not such sudden and identifiable events that the gradual erosion resulting therefrom may be attributed to a specific period of time. The rise and fall of the water levels of a body of water is a normal process, and damage resulting from normal high water levels alone lacks the characteristics of a casualty loss under § 165. Thus, where the taxpayer’s loss was due to progressive deterioration rather than some sudden, unexpected, or unusual cause, such loss is not a deductible casualty loss for Federal income tax purposes.
Another situation involves expenditures by taxpayers for the construction of protective works or for moving their homes back from their original locations to prevent probable losses from future storms. In such cases, no casualty loss deduction is allowable under § 165 of the Code because § 165(c) expressly limits a casualty loss deduction to losses of property. Such expenditures are within the purview of § 263, which provides that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of the property.
Where a casualty loss is allowed for the loss of property, the amount of loss deductible is measured by the excess of the value of the property just before the casualty over its value immediately after the casualty (but not more than the cost or other adjusted basis of the property), reduced by any insurance or compensation received. In the case of property not used in a trade or business, such amount is further reduced by $100 for each casualty.
Notes and Questions:
1. For which of the following do you think there should be an allowable deduction for a casualty loss?
- moth damage to a fur coat?
- damage caused by a quarry blast?
- freezing and bursting of water pipes?
- damage from disease and insect attack to a tree?
- damage to automobile engine caused by freezing conditions?
- damage to automobile caused by taxpayer’s negligent driving?
- damage to automobile caused by rusting and corrosion?
See generally Standard Federal Income Tax Reporter (2011), ¶ 10,005.023.
2. Upon what narrow ground does Revenue Ruling 76-134 deny a casualty loss deduction? What tax treatment does the Revenue Ruling specify for such expenditures?
3. Calculation of the personal casualty loss deduction.
- Section 165(h) limits the losses that an individual may deduct as casualty losses.
- Reg. § 1.165-7(b)(1) limits all casualty losses – whether trade or business, transactions entered into for profit, or personal – to the lesser of the property’s fmv before the
casualty reduced by the fmv of the property after the casualty OR the property’s adjusted basis.
- If the property is used in a trade or business or held for the production of income AND it is totally destroyed by the casualty, the allowable loss is limited to the adjusted basis of the property.
- What is the theoretical underpinning of these limitations?
- Section 165(h)(1) limits the deductibility of the personal loss for each casualty to the amount by which the loss exceeds $100.
- Section 165(h)(4)(A) defines “personal casualty gain” to be “recognized gain from any involuntary conversion of property” resulting from a casualty. Section 165(h)(4)(B) defines “personal casualty loss” to be a casualty loss after reduction by $100.
- Section 165(h)(2) limits the deductibility of all personal casualty losses to the amount by which they exceed personal casualty gains and by which this net amount exceeds 10% of a
taxpayer’s adjusted gross income. Taxpayer may reduce his/her adjusted gross income by the net personal casualty loss in making this 10% determination. § 165(h)(5)(A).
- In the event personal casualty gains exceed personal casualty losses, taxpayer must treat all such gains and all such losses as if they resulted from the sales or exchanges of capital assets. § 165(h)(2)(B).
4. A taxpayer suffering a casualty loss in a federally declared disaster area may elect to claim the casualty loss deduction for the taxable year immediately preceding the taxable year in which the disaster occurred. § 165(i)(1). The casualty loss is then treated as having occurred in the year in which the deduction is claimed. § 165(i)(2). This provision may help get funds into the hands of the victims of federally declared disasters quickly.
5. Do CALI Lesson, Basic Federal Income Taxation: Deductions: Personal Casualty Loss Deduction: Computation, Limitations.