How do I report the Casualty on My Tax Return?
For tax purposes, we must first determine if we have a gain or a loss. From a high level, a gain or loss is calculated by taking the insurance proceeds less your cost basis in the property. Let’s say you purchased your home for $350k and your home was destroyed in a fire and you received $800k of insurance proceeds, then your gain on the casualty could be $800k – $350k = $450k gain. If you were uninsured, then your loss could be $0-$350k = $350k loss. (We say “could be” in this description above, because this is a very simplistic overview of the calculation. There is a LOT more that goes into it which is why we recommend you work with an Enrolled Agent or other qualified tax professional when calculating your gain or loss on your casualty).
Reporting a Loss
The tax deductible portion of the loss is calculated on Form 4684. While the form is straightforward, obtaining the amounts to put on the form is not so obvious, particularly when there is a complete loss. Many taxpayers, unless they have electronic copies of their records backed up on a cloud service, will struggle to obtain the cost of the house. If you purchased your house, then those records may be available from the Title Company or your County Recorder’s Office. If you built your house your challenge will be much more significant.
Calculating the loss is no easy task. The IRS has provided “safe harbor” methods that taxpayers can use in Revenue Procedure 2018-08. The advantage of using a safe harbor method is that you do not need to attached detailed documentation to support the loss calculation. The safe harbors are:
- If the cost of repair is less than $20,000, then you can use the lesser of two written estimates. Both estimates must break down the repairs and itemize the costs to restore the property. Costs may not be used that increase the value of the property.
- If the cost of repair is $5,000 or less, then a good-faith estimate may be used. The taxpayer must maintain records detailing how the estimate was prepared.
- You may use the estimated loss determined by the insurance company for the repairs.
For federally declared disasters:
- You may use a signed and binding contract with an independent contractor for the repairs (or reconstruction) of the house. The estimate must show itemized costs to restore the property. Costs for improvements or additions that increase the value must be excluded.
- You may use the appraisal prepared for the purpose of obtaining a loan from the Federal Government that sets forth the loss.
For personal belongings Revenue Procedure 2018-08 details in Section 5 how to evaluate your loss and the depreciation factors to be used.
Revenue Procedure 2018-09 elaborates on Revenue Procedure 2018-08 and includes indexes that can be used in calculating the loss. Anyone preparing an estimate of the losses from such disasters must be familiar with the content of the two Revenue Procedures. Note that the adjusted basis must be used to calculate any losses. For personal residences this is likely the cost to purchase the house plus significant improvements less tax credits received (e.g., energy improvements). For income-producing property the adjusted basis is also reduced for depreciation that was allowed or allowable whether taken or not.
Reporting a Gain
Disaster gains for your primary residence may be addressed in one of or a combination of two ways. The first is the personal exclusion for the sale of your primary residence identified as IRC §121. That could exclude up to $250,000 in gains for each person. The information of the sale should be reported on Form 8949 with an adjustment in basis up to the limit to reduce the gain. Documentation should be attached to the return to substantiate the calculation of the gain.
The second tool is the deferral of the gain using IRC §1033. This results in an adjustment of the basis of the new property for the gain deferred. Long term this adjustment will increase the capital gains should the property be sold. With this tool all details in connection with this deferral must be included with the tax return. This includes the description of the property, date and type of conversion, computation of gain (i.e., documentation on the adjusted basis of the property, calculation of the value of the damage, breakdown of the payment by the insurance company, etc.), decision to replace, etc. If the property is replaced with different like property, then there must be documentation attached to the return in the year that the replacement property is obtained. This may mean that documentation of the details is attached to two separate tax returns.