Casualty Loss Deductions and Disasters

Recent natural disasters such as hurricanes Helene and Milton and the California wildfires have left many families and businesses grappling with significant losses. Amidst the recovery process, insurance recoveries can provide vital financial relief. However, understanding the tax implications of these funds and the related casualty loss rules is crucial to avoid unexpected tax consequences. 

Generally, the tax treatment of casualty losses depends on the type of property lost, how the property was used, and the amount of insurance proceeds the taxpayer received for disaster recovery. Limitations on the deductibility of casualty losses are determined by whether the property lost is personal property or business property.  

Business Casualty Losses

Under IRC Sec. 165(c), taxpayers are generally allowed a deduction for casualty losses incurred in a trade or business or any transaction entered into for profit. A casualty loss is defined as the damage, destruction, or loss of property resulting from a sudden, unexpected, or unusual identifiable event (e.g., fires, hurricanes, storms, etc.). The casualty loss amount is generally the lesser of the taxpayer’s adjusted basis in the property or the decrease in the fair market value (FMV) due to the casualty. If the property is “totally destroyed” and the FMV of the property was less than the adjusted basis prior to the casualty, the adjusted basis will be allowed as the loss amount.

The deductible amount of a casualty loss is the casualty loss amount reduced by any insurance proceeds or other reimbursement a taxpayer receives or expects to receive on the casualty. If insurance proceeds exceed the casualty loss, taxable gain will result unless those proceeds are used to acquire qualifying property under the involuntary conversion rules (discussed below). Additionally, taxpayers who suffer a disaster loss can elect to claim the disaster loss in the prior tax year (discussed further below).

Personal Casualty Losses

IRC Sec. 165(c)(3) allows a deduction for losses resulting from a casualty of personal-use property.  However, this deduction is limited to losses attributable to a “federally declared disaster” for the 2018-2025 tax years.

The term “federally declared disaster” means any disaster subsequently determined by the of the United States to warrant assistance by the federal government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act (Stafford Act). This includes a major disaster declaration or an emergency declaration under the Stafford Act. There are three specific types of personal casualty losses:

1. federal casualty losses,
2. disaster losses, and
3. qualified disaster losses.

All three types of losses refer to federally declared disasters, but the requirements and limitations for each loss vary.

A loss categorized as a federal casualty loss or a disaster loss is deductible as an itemized deduction, subject to the $100 per casualty and 10% AGI limitations. As is the case with business losses (discussed above), personal disaster losses may be claimed in the preceding taxable year. 

Qualified Disaster Loss

A qualified disaster loss is an individual's casualty loss of personal-use property that is attributable to certain major disasters declared by the President under the Stafford Act. Individuals that suffered a qualified disaster loss are eligible to claim a casualty loss deduction, to elect to claim the loss in the preceding tax year, and to deduct the loss without itemizing other deductions on Schedule A. Such losses are subject to a $500 per casualty limitation but are not subject to the 10% AGI limitation. (Note: As a result of the Disaster Tax Relief Act of 2023, losses due to the recent Los Angeles County wildfires should be treated as qualified disaster losses.)

Involuntary Conversions

In some instances, taxpayers may receive insurance proceeds, which could result in a casualty gain. IRC Sec. 1033 allows taxpayers to defer these casualty gains provided they replace the property within a certain period of time (“replacement period”). The replacement period begins on the date property is disposed and typically ends two years after the close of the tax year in which any gain is realized. The replacement property must be similar or related in service or use to qualify for this deferral, meaning the taxpayer’s end use of the replacement property must be substantially the same as the property being replaced. The taxpayer will recognize the deferred gain upon the sale of the property.

Rules for Principal Residence

IRC Sec. 1033(h)(1) allows the application of involuntary conversion rules to a taxpayer’s principal residence, provided the property is in a federally declared disaster area. If taxpayer’s principal residence (or its contents) falls under the scope of IRC Sec. 1033(h)(1), the following rules apply:

1. No gain is recognized on the receipt of insurance proceeds for “unscheduled” personal property (i.e., property that is covered under an insurance policy) considered to be contents of the residence, regardless of the taxpayer’s basis in the unscheduled personal property or how insurance proceeds are used,
2. Any insurance proceeds for the residence or its “scheduled” contents (i.e., items of high value that are insured for a specific amount on a policy rider) are treated as a common pool of funds, which may be used to replace any type of property. The taxpayer may elect to recognize gain only to the extent that the funds exceed the cost of replacing the residence and its contents, and
3. The replacement period is extended from two years after the close of the year gain is first realized to four years.

Taxpayers who have been impacted by recent natural disasters should reach out to a trusted tax advisor to determine if they are eligible to deduct casualty losses or if they qualify for any other tax relief.