Whether or not holding costs would be deducted depends on the specific property and circumstances. For a home, whether or not holding costs and lost rents should be considered will vary from case to case. For income properties closed because of a casualty, the lost revenue and cost to replace tenants would reduce the market value of the property after the casualty.
Holding Costs Example
Hurricane Ike flooded the first floor of a 100,000 square foot, two-story office building. The building had been 85% occupied. Tenants will be able to occupy the second floor about 2 to 4 weeks after the storm. However, the first floor will not be available for occupancy for 9 to 15 months. Tenants have the option to terminate their lease if space is not available for more than 30 days. The owner believes all first floor tenants will relocate.
Time to Rebuild
Renovating a property is always an arduous process. Renovation following a major casualty is even more difficult since insurance adjustors, insurance company staff and contractors are busy. The first step in the restoration process is to negotiate a settlement with the insurance company. This is sometimes a quick and painless process. In other cases, insurance companies use time as a negotiating weapon since the property owner must continue loan payments even if the property is partially or totally vacant. For income properties, it is not unusual for this process to take 2 or 3 months. It sometimes takes 6 to 12 months. In addition, getting funding once work is partially complete can also be a slow process.
It is also necessary to obtain contractors or a general contractor. This process can begin prior to finalizing an insurance claim. However, contractors will do work as property owners can commit to payment. A contractor who agreed to do the work may not be available once the insurance claim has been settled.
Time / Cost to Lease Vacant Space
It takes time to lease and build-out commercial real estate. It is also expensive. In addition to the revenue lost while space is renovated and leased, additional costs include leasing commissions and tenant improvements.
Determining the Casualty Loss
Obtain an appraisal from a qualified appraiser. For real estate, it should be a real estate appraiser. For commercial real estate, confirm the appraiser’s experience with commercial real estate appraisals.
The appraisal should provide a value for the property: 1) immediately before the casualty and 2) immediately after the casualty. The valuation after the appraisal should consider issues which would impact the property including: 1) costs of renovation, 2) entrepreneurial profit, 3) lost rents prior to the property returning to stabilized occupancy, 4) tenant improvements, 5) leasing commissions, and 6) potential stigma. Depending on the level of destruction, the level of business activity in the area could decrease. This could reduce the level of business for either residential or commercial properties. The issue is not if the level of business decreases after the casualty. The issue is the perception immediately after the casualty.
The casualty loss deduction is limited by the amount of the remaining basis of improvements. For example, prior to the casualty, your remaining depreciable basis for an apartment complex was $4,000,000. This includes $500,000 for land and $3,500,000 for improvements. The casualty loss determined by the appraiser is $1,230,000. Since the casualty loss is less than the remaining depreciable basis for the improvements ($3,500,000), you can deduct the entire amount.
Casualty loss deductions are often substantial and material. In many cases, they completely eliminate the taxpayer’s income taxes for one or two years. Documentation is essential. Photographs of the property can clearly document the scope of damage. Damage can also be documented by written communications with tenants, vendors, insurance adjustors and lenders. The appraisal should clearly explain the basis for calculating the casualty loss. The essential portion of the appraisal is the analysis regarding factors impacting market value immediately after the casualty.
Discuss your tax situation with your CPA or tax return preparer. If your property is located in a presidentially-declared disaster area, discuss whether you should seek a refund for the prior year or claim the tax deduction for the current year. (If the property is owned by a limited partnership with multiple partners, also consider the cost of having each limited partner file amended returns for the prior year.) Plan to have all necessary documentation when you meet with your tax preparer.
Natural disasters bring much heartache, pain and financial distress. Congress has provided specific tax benefits for those suffering casualty losses. It is prudent and responsible to reduce your taxes with this clear-cut source of tax relief.