This category of itemized deductions is for catastrophic, uninsured losses.
For all intents and purposes, casualty and theft loss deductions are available only to those of modest income who itemize deductions—or those who are hit by catastrophic losses such as resulting from hurricanes, tornadoes or earthquakes. Here's why:
The amount of any uninsured loss must be reduced by $100. If you suffer more than one loss during the year, the first $100 of each is ignored by the tax law.
Much tougher is a restriction that permits a deduction only when your remaining losses exceed 10% of your adjusted gross income (AGI). You get a deduction only for the amount above the threshold. Unlike the $100 rule, the 10% threshold does not apply to each separate casualty or theft. It applies to the total of your losses during the year, after each one has been trimmed by $100.
Assume you are mugged and the thief gets away with $200 in cash and $3,500 worth of jewelry, and this is the only casualty or theft you suffer during the year. For tax purposes, you first reduce your loss by $100 and then subtract 10% of your AGI from the remaining $3,600. If your AGI is $30,000, the $3,000 reduction would leave you with a $600 loss deduction. If AGI is $36,000 or more, the 10% rule would bar the deduction altogether.
The bottom line is that if you own valuable property, you should insure it.
Special Rules for Hurricane Victims: The devastation inflicted in 2005 by Hurricanes Katrina, Rita and Wilma led Congress to carve out a special tax break for victims. For casualty losses in the areas hit by the storms, neither the $100 nor 10% of AGI reduction applies.
According to the law, it is damage to or destruction of property caused by an identifiable event that is sudden, unexpected or unusual. As you may assume, taxpayers and the IRS often disagree over what fits the bill.
Clearly, damage from these "identifiable events" count: earthquakes, lightning, hurricanes, tornadoes, floods, storms, volcanic eruptions, sonic booms, vandalism, riots, fires, car accidents and, oh yes, shipwrecks.
What if you accidentally knock a vase off its pedestal and into a million pieces? The IRS says that's not a casualty. How about when Rover romps through the house, knocking down the cabinet that holds your television, VCR and stereo? Again, the IRS says there's no tax deduction to help pay for the damage. What if you're driving along and your car's engine suddenly freezes up, resulting in thousands of dollars worth of damage? You guessed it: no deduction. The IRS figures the damage was due to normal wear and tear on the engine over a lengthy period of time.
What if you lose something valuable, like a diamond ring? That's not a casualty in the eyes of the tax law. However, if the ring falls into a garbage disposal, the damage would qualify for a casualty-loss deduction. So would the loss of a diamond if you can show it happened because the setting was damaged when the owner's hand was slammed in a car door.
Damage caused by termites or moths doesn't qualify as a casualty. It lacks the suddenness requirement. However, when the cause of damage can possibly be laid to progressive deterioration, you may still have a deductible loss. If your hot-water heater bursts, for example, any resulting water damage qualifies even though the cost of repairing or replacing the heater does not.
Even if the damage is your fault, you can earn a casualty loss deduction unless willful negligence is involved. If you're responsible for a car crash, for example, or accidentally apply a chemical that kills your lawn and shrubs, the damage can qualify as a casualty loss.
You also qualify for a deduction if you lose money because a bank or other financial institution goes under and your deposits aren't insured. You actually have a choice of how to deduct such a loss: either as a casualty loss or as a non-business bad debt, which is treated as a short-term capital loss. There are restrictions either way.
The casualty loss is subject to both the $100 reduction and the 10% test. The non-business bad debt, as other short-term losses, is deductible first against capital gains and then against up to $3,000 of other income. (Any leftover bad-debt loss would be deductible in future years.) Although you may claim a casualty loss in the year you can reasonably estimate your loss—probably the year the bank goes under—you can't claim a bad-debt deduction until the actual amount of the loss is determined, which may well be in a later year.
The answer here is much easier than when determining what qualifies as a casualty. You have a theft loss when property you own is taken illegally. The key here is to show that the property was stolen rather than lost or mislaid. Be certain the theft is reported to authorities. If you are the victim of an investment scam or other swindle, whether or not your loss qualifies for a deduction turns on whether the venture that separated you from your money was illegal under federal, state or local law.
There are special rules if you suffer a loss as a result of an event that prompts the President to declare your area a federal disaster area—which often happens in connection with floods, fires, hurricanes, tornadoes and earthquakes.
Generally, you deduct a casualty loss on the return for the year the damage occurs. However, when the loss is in a Presidentially declared disaster area, you can write off your loss on the return for the previous year. This unusual option is designed to put a tax refund in your hands to help pay for the damage. You can use this provision even if you've already filed your return for the preceding year. You can order your tax-refund check via an amended return.
Assume, for example, that a hurricane caused $20,000 of uninsured damage to your home in 2006. Usually, you would report the loss on your 2006 return, filed in the spring of 2007. But if the President declares your town a disaster area, you could claim the loss by amending your 2005 return.
If your 2006 adjusted gross income was $50,000, the casualty-loss deduction for the $20,000 loss would be $14,900—$20,000 minus $100 minus $5,000 (10% of AGI). If you were in the 15% bracket, the amended return would bring a refund of up to $2235 depending on how much tax was actually paid that year. An important consideration in deciding which year to claim the write-off is how your adjusted gross income will compare. Because of the 10% rule, your tax savings will usually be greater in the year your AGI is smaller. That would not necessarily be the case, though, if you are in a lower tax bracket in the lower-earning year.
The amount of your casualty or theft loss is reduced, of course, by any reimbursement you receive from insurance. If you have insurance, in fact, you must file a claim or forfeit your right to a tax deduction for the insured part of the loss. Before that rule was written into the law, some taxpayers chose to go for the tax write-off rather than file a claim and risk cancellation of their policy or an increase in premiums. That's no longer an option.
If you can reasonably expect to be reimbursed for part or all of your loss—through insurance or a damage suit—you're supposed to trim your deduction by the amount you expect to get, even if you won't get it until a future year. If you wind up getting less than you expect, the difference is considered a casualty loss in the year of the final settlement. At that time, the amount would again be subject to both the $100 and 10%-of-AGI rules. Since that could easily wipe out any tax benefit, be particularly careful when estimating future reimbursements.
When insurance pays for your living expenses after you lose the use of your home, the payments are not counted as reimbursement for your loss and therefore do not reduce your deduction. In some cases, however, the IRS views such payments as taxable income if the money covers normal living expenses rather than extra expenses resulting from the casualty.
Say, for example, that the apartment you rent for $1,000 a month is damaged by fire and you are forced to live in a motel for two months while your place is repaired. The motel bill is $1,500 a month, of which your insurance policy pays $1,000. Because $500 a month pays the extra expense (the difference between your rent and the motel bill), that part of the insurance payment is tax-free. The other $500 a month is considered payment of normal expenses and should be reported as income. In a similar situation, a homeowner who had to continue mortgage payments on the damaged house while living in the motel would not report any of the insurance reimbursement as income because the entire motel bill is an added expense.
Regardless of how much you suffer from a casualty or theft, the tax law may view you as a winner and demand that you report insurance reimbursement as taxable income. This seemingly contradiction occurs when the reimbursement is more than your adjusted basis in the lost or damaged property.
Say, for example, that an item of antique furniture is stolen from your home. Assume you paid $800 for the antique but it was worth much more when it was stolen. Thanks to a rider on your insurance policy, you are reimbursed $3,000. As far as the IRS is concerned, the $2,200 difference between your $800 basis and the $3,000 is profit and therefore, taxable income.
Or assume that you have a replacement-value clause in your household insurance policy. After a fire, you determine that your basis in destroyed furniture and appliances is $10,000, but the replacement value paid by your insurance company is $15,000. Taxable gain: $5,000.
There is an important exception to this rule. If you use all the insurance proceeds to buy replacement property—that is, items similar to or having a related use as the lost or damaged property—you don't have to report any of the money as income. To dodge the tax bill on what the IRS sees as excess reimbursement, the replacement property must be purchased within two years of the end of the year in which you are reimbursed. (The replacement period is four years if the loss was incurred in a Presidentially declared disaster.)
The basis of the replacement property is its cost minus the amount of "gain'' from the insurance. This rule doesn't matter much when you're dealing with things like furniture or appliances, but it can be vitally important when a house is involved.
Assume that a rental property you own is destroyed by fire. Say your basis in the house is $50,000 but it's worth far more at the time of the fire and you receive a $150,000 insurance settlement on the house itself. That's a $100,000 gain—just as if you had sold the house for $150,000. You avoid the tax bill, however, by spending $200,000 on a new home within the two-year replacement period. What's the basis of the new place? It's $100,000: the $200,000 cost minus the $100,000 gain from the casualty. Another way to look at it is that you carry over your original $50,000 basis and add to it the extra $50,000 you put into the new place—over and above the "excess" insurance settlement.
The amount of your loss is generally the decrease in fair market value of the property or your adjusted basis in the property, whichever is less. The decrease in market value is the difference between what the property was worth before and after a casualty or the full market value in the case of a theft. The question of value turns on what a disinterested person would pay for the property. You don't get any credit for sentimental value. The adjusted basis is usually your original cost plus the cost of any improvements you've made.
You may need appraisals to set the before and after market values, although what you have to pay for repairs—after an automobile accident, for example—can serve as evidence of your loss. If you are restoring landscaping after a storm, you can base your casualty loss on what you pay to remove or prune damaged trees and shrubs and for the replanting necessary to restore your property to its value before the storm.
Note that your loss doesn't depend on the replacement value of the damaged or stolen property. Say that you bought a chair for $400 and that four years later it is destroyed by fire. At the time, you could have sold the used chair for $100, but to replace it with a comparable new chair would cost you $700. What's your casualty loss? The decline in fair market value—$100—caused by the fire.
When your loss involves several separate items, as would be the case if your home burns or thieves clean out your apartment, you are expected to calculate the loss on each item rather than come up with an overall estimate. The IRS offers a free booklet—Publication 584, Nonbusiness Disaster, Casualty, and Theft Loss Workbook—to help you inventory lost, damaged or stolen items and determine your deductible loss. (Even if you don't suffer a loss, the booklet is helpful as a handy tool for keeping a household inventory. If you have Internet access, visit www.irs.gov/pub/irs-pdf/p584.pdf and download a copy of this publication in PDF format. You'll need Acrobat Reader, so if you don't have this program, visit www.adobe.com to download a free copy. )
As with any deduction, if you are audited you'll need evidence to back up your write-off. For starters, keep any newspaper articles reporting on the calamity that caused your loss, whether it was a fire, major storm, auto accident or robbery. Also make copies for your tax file of any pertinent police or fire reports. You'll also need to show that you owned the property at issue. You can't claim a casualty-loss deduction for damage to an auto registered in your daughter's name, for example, even if you pay for the repairs.
Proving the size of your loss is tougher. In addition to receipts for repairs, you may need appraisals of the property's value before and after the loss. Before-and-after photographs can also serve to back up your deduction. Although it may be impossible to take such pictures after the casualty or theft, it's still a good idea to maintain a regularly updated photo file of your belongings. Such pictures may also serve to jog your memory after a fire or theft when you're putting together a list of your losses. The cost of photos and what you pay for appraisals cannot be added to your casualty loss but may be deducted as miscellaneous expenses if you pass the 2%-of-AGI threshold.
The $100 and 10% restrictions on casualty and theft losses apply only to personal-use property, such as your own home, car or personal possessions. If you suffer a loss to business property, such as a business auto or a rental house, you can deduct the full loss. You don't reduce it by either the $100 or 10% of AGI required when figuring a personal casualty or theft loss.