As the U.S. mobilizes on a number of fronts to assist in the recovery from Hurricane Katrina, the Internal Revenue Service has mobilized as well. The IRS has already released several information releases in response to Hurricane Katrina.There have already been disasters this year involving droughts, floods, tornadoes and other hurricanes. The IRS had released relief guidance earlier this year involving Hurricane Dennis and a tornado in Wyoming. It is seldom, however, that a disaster of the scope and national impact of Hurricane Katrina comes along.
Tax practitioners throughout the country this year are likely to be dealing with disaster questions. Tax practitioners along the Gulf Coast not only have their clients' disasters to worry about, but disasters to their own personal lives and businesses as well. A number of tax practitioners around the country have offered assistance to tax practitioners directly affected by the disaster to help them serve their clients' needs until they can get their businesses back up and running.
Most tax practitioners do not have to deal with disaster losses on a routine basis, so a review of the basics, along with a summary of tax relief specific to Katrina, may be helpful.
Deducting casualty losses
Businesses can generally deduct business-related losses. The loss generally cannot exceed the taxpayer's adjusted basis in the property, and any deduction must be reduced by the amount of any insurance recovery. Losses are also deductible in connection with a transaction entered into for profit, although the losses deductible here will generally be limited to the associated income earned.
Perhaps ironically, if insurance recovery exceeds tax basis, there can even be a taxable casualty gain, unless like-replacement property is purchase within the time allowed under Code Sec. 1033. Personal casualty damage outside of the business setting cannot even use Code Sec. 1033, and will yield taxable gain to the extent that net casualty gains exceed net casualty losses.
Personal losses are generally not deductible, unless they arise from a casualty or theft. Such personal losses are only deductible as itemized deductions. From each loss, $100 must be subtracted, and the total casualty losses are only deductible to the extent that they exceed 10 percent of adjusted gross income. The casualty loss deduction is subject to the general phase-out of itemized deductions. Casualty loss deductions are allowed, however, for alternative minimum tax purposes. Taxpayers would, of course, have to itemize, rather than claim the standard deduction, to claim the casualty loss deduction.
In calculating the amount of the loss, the taxpayer will need to determine the fair market value of the property immediately before and after the loss, the salvage value of the property, cost or other adjusted basis in the property, and the amount of insurance or other compensation received with respect to the property.
The cost of repairs can serve as evidence of the loss of value, if the taxpayer can show that the repairs were necessary to restore the property to its pre-casualty condition, that the amount spent is not excessive, and that the repairs do not make the property more valuable than it was before the disaster occured.
Given that many records may have been lost along with the loss of property, the taxpayer may have to get an appraiser's opinion as to the value of the property before the disaster.
Casualty losses arising from official disaster areas may be deducted in either the year that the loss occurred or in the immediately prior year, permitting taxpayers to choose the most favorable year to claim the loss and, if the prior year is elected, possibly getting a tax refund from the IRS sooner than would be possible if the loss were to be claimed on the current year's return. Although an amended 2004 return may be filed immediately to claim a refund based on a casualty loss, many disaster victims would be better served by waiting until the 2005 tax year closes and all data from the 2005 and 2004 tax years can be compared more accurately.
Businesses can generally carry back net operating losses from their businesses for up to two years. Individuals with non-business casualty losses should also be made aware that such casualty losses are treated as business losses for purposes of calculating the net operating loss carryback.
Also, Internal Revenue Code Sec. 172(b)(1)(F) provides that such losses, in addition to small business and farming losses, in presidentially declared disasters may be carried back for up to three years, rather than two years. Tax practitioners should review the benefits of the net operating loss carryback for their individual as well as their business clients.
Small business owners may also be able to take advantage of special involuntary conversion rules for disaster damage. These rules provide for nonrecognition of gain on the purchase of replacement property. These rules are liberal enough to permit nonrecognition of gain even if the taxpayer decides to enter into a new business venture after the disaster.
Disaster relief payments
Pursuant to legislation enacted after the terrorist attacks on Sept. 11, 2001, qualified disaster relief payments are excluded from gross income. This includes relief payments associated with a presidentially declared disaster to reimburse an individual for reasonable and necessary personal, family, living or funeral expenses; expenses to repair a personal residence and to repair or replace its contents; and payments made by a federal, state or local government in connection with a qualified disaster.
Qualified disaster relief payments do not include payments for any expense compensated for by insurance or otherwise, payments in the nature of income replacement, unemployment compensation, and payments in the nature of business income replacement.
Legislation enacted in 2005 clarified that this exclusion also extended to certain disaster mitigation payments from the Federal Emergency Management Agency to help individuals prepare for or mitigate natural disasters.
Taxpayers in the presidentially declared disaster area for Hurricane Katrina, including parts of Alabama, Florida, Louisiana and Mississippi, will have until Oct. 31, 2005, to file tax returns and submit tax payments. The IRS will abate any late filing or late payment penalties that would otherwise apply. The disaster designation "Hurricane Katrina" is to be marked in red on the relevant filings.
The IRS also granted a penalty waiver period for these areas for employment and excise tax deposits from Aug. 29 to Sept. 23, 2005. Further, the IRS stated that some of these deadlines may be extended for the hardest-hit areas.
The IRS also announced the suspension of low-income housing rules to permit occupancy by displaced persons who do not qualify as low-income. In addition, the IRS provided guidelines for expedited review and approval of organizations seeking exempt status to provide hurricane relief, extended minimum funding plan contribution deadlines, and released dyed diesel fuel for road use.
Given that the IRS has promised additional Hurricane Katrina relief guidance, it is likely that additional guidance has been issued since this column went to press.
Congress is also looking at a stimulus package for hurricane victims in order to help offset any negative impact on the economy. Congress has already passed legislation providing greater access to tax-favored mortgage bonds for rebuilding homes in presidentially declared disaster areas. Tax breaks effective next year in the recent Energy Act may also provide some assistance in rebuilding energy-efficient homes and commercial properties.
Tax practitioners throughout the country are likely to encounter disaster-related tax issues this year, given the scope of the disasters that have already befallen the country, especially Hurricane Katrina. Keeping abreast of the existing rules and the new developments as they come from Congress and the IRS during the course of the remaining year will help practitioners obtain for their clients as much tax relief as possible to offset their losses.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a WoltersKluwer company.
Register or login for access to this item and much more
All Accounting Today content is archived after seven days.
Community members receive:
- All recent and archived articles
- Conference offers and updates
- A full menu of enewsletter options
- Web seminars, white papers, ebooks
Already have an account? Log In
Don't have an account? Register for Free Unlimited Access