Hurricane Ike inflicted a steep penalty on the Texas Gulf coast. However, there is an inconspicuous benefit casualty loss tax deductions. Taxpayers may be able to take a 2008 deduction if either personal or business property was damaged by Hurricane Ike.
Some taxpayers will be able to completely eliminate their 2008 federal income taxes by utilizing a casualty loss deduction. It is not necessary to sell the property to be eligible for the write-off. In addition, even if insurance proceeds completely reimburse the cost of construction, the taxpayer likely qualifies for a substantial write-off. This is a generous tax benefit for those affected by a casualty.
Get a Refund for Prior Year Taxes
For a major casualty such as Hurricane Ike, in a presidentially declared disaster area, the deduction can be used in either the current or preceding tax year. Hence, it is possible to claim a large income tax refund (of the prior years income taxes), as a result of Hurricane Ike.
What is a Casualty Loss?
A casualty loss is damage, destruction or loss of property from any sudden, unexpected and unusual event. Casualties can include fire, flood, hurricane, tornado, and earthquakes. The casualty loss is calculated as follows: market value of property immediately before the casualty, less the sum of: a) market value immediately after the casualty and b) insurance proceeds.
Im Insured; Do I Qualify
A frequent misconception is the owner of insured property does not qualify for a casualty loss. This simply is not true. Even if insurance proceeds fully fund restoration, the owner probably qualifies for a casualty loss. The casualty loss is really only subject to casualty loss limitations ($100 per casualty and in excess of 10% of adjusted gross income for personal-use property).
Huh? I get a deduction even if fully insured?
Yes, because of the procedure for calculating the casualty loss. The difference in value before and after the casualty is more than the cost of repairs. Lets consider an example. You have been planning to purchase a house in Galveston. Would you rather purchase: 1) a house in good condition with no storm damage or 2) a house seriously damaged by a storm. Lets now be more specific. The value of both houses (in good condition) would be $500,000. The damage to the second house is estimated at $150,000. You can purchase the second house for $350,000 ($500,000 less $150,000 of restoration costs).
Market Value and Entrepreneurial Profit
Market value is the price for which a property would sell, assuming reasonable exposure to the market, knowledgeable buyer and seller and that neither party is under duress to act. Entrepreneurial profit is the compensation required for an investor to assemble and coordinate labor, capital and assets. In this case, it is the compensation required to: 1) negotiate the insurance claim, 2) supervise contractors and 3) coordinate capital (debt and equity to purchase and renovate the house). No reasonable person would purchase the damaged house without compensation for the risk and work required to renovate the property.
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 experience with commercial real estate appraisal. 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 taxpayers 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.