LOSS VALUATION - APPRAISAL METHOD
Figuring the Loss - Market Value Method
The tax law provides two methods for computing a deductible loss in the event of a casualty event. The “Cost of Repairs Method” and the “Market Value Approach.” This entry only deals with the “Market Value Approach.”
If there is insurance covering the loss and the insurance proceeds exceed (or are expect to exceed) the “cost basis” of the lost property, then for income tax purposes, there is no loss and there is a “gain” that is covered under the involuntary conversion rules as a deferred gain or under the casualty loss rules as a “sale” of a “capital asset.”
If there is no insurance, or the insurance does not cover the recovery of the “cost basis,” then there might be a loss.
Use of the “Market Value Approach” requires that there be appraisals by qualified appraisers of the fair market value (FMV) just prior to the event and just after the event. The difference between the two values is the loss, unless that is greater than the “cost basis” after deducting any insurance proceeds from the “cost basis.”
Most people assume that the deduction amount will be the cost of restoring the property to its condition prior to the loss less the insurance proceeds. This belief is even reinforced by the Internal Revenue Service positions warning that including drops in economic values due to the general deterioration in values in the affected area due to buyer resistance are not part of the loss. Insurance is purchased to return the damaged property to its pre-event condition; that is not necessarily an absolute indicator of the loss in value.
Cost of repairs is an important consideration in the process, but making a determination of the amount of the loss is not a simple task. For tax purposes, you must be able to support your deductions and thus you need to determine the actual estimated market values before and after the loss. In order to get these values, it is important to have access to the right experts and information. If you have an expectation of a large deductible loss, you will need to hire a qualified real estate appraiser. Most important to this process is that the appraiser be knowledgeable about the applicable IRS rules that apply to these special situations. A standard appraisal prepared for a refinancing or a sale may not be adequate.
Additionally, the IRS will often accept an appraisal prepared for an SBA loan application related to the recovery from the event. This will only cover the post-event value. You will need one for the pre-event value also.
Additionally, the valuation process that is used for tax purposes is not identical to that required for insurance claim purposes. For tax purposes the drop in values is the determining factor. For insurance purposes, the issue is bringing the property back to its pre-event condition; value is usually not a major part of the insurance determination process.
For smaller losses, where the $1,500 or more price tag for the appraisal may be prohibitive, you might ask a real estate broker to assist you in gathering information on comparable properties' market values before and after the loss. Additionally, the realtor may be able to suggest the amount of the adjustment for the general economic decline related to the disaster area (buyers’ resistance that is not part of the loss) and differences in the qualities of the properties used for the comparison. But keep in mind that a realtor is not an appraiser. An appraiser may be a realtor.
Where the loss is part of a large, widespread disaster, where substantially all homes in the area have been lost, comparables may be impossible to determine. Realtor’s and appraisers archives may be useful. You will be developing the estimated costs of repairs using other experts. If this is the way you are going to proceed, keep in mind that the database that real estate brokers use may only go back six months in time from the date of inquiry into the system. More history may be available, but require more effort to access. Therefore, much of the "before" data may disappear before you have had the opportunity to access it. Newspapers sometimes report sales prices for properties sold periodically. Old issues may be useful. In some instances, sales that closed up to four months, or even longer, after the loss, may be based on prices that were negotiated prior to the disaster. These subsequent sales may thus not be indicative of post-loss conditions.
While the difference between the two appraisals (limited to the “cost basis”) is the foundation for the computation of the loss in these situations, the IRS will look to the actual cost of repairs as a comparison for the reasonableness of the valuations; but that comparison does not change the method to the “cost of repair method.”
You will also need some way of determining the extent of damage to the sold properties that you are using for comparisons, whether the post-loss sales were based on "as-is" condition, repair of only cosmetic damage, or a full structural restoration to pre-loss quality. This may be very difficult to ascertain. It may be worthwhile for you to visit open houses in your neighborhood. Where that is possible, or where there are any properties being sold on the perimeter of the loss area these properties should be documented in your file. Gather sales materials, ask questions and note status of properties for future reference – take pictures where possible. You may have to justify your own information as well as be able to refute IRS information.
Remember if you deduct a casualty loss on your year of loss tax return, it is not likely that it will be reviewed for audit until sometime after a year later. Your detail notes and pictures of comparable homes may be very valuable data if you are audited. Before you make any decisions, discuss your individual facts with a tax professional. There are too many variables involved and the dollar amounts are too large for you to depend on conclusions reached based solely on a neighbor's situation to be your basis of any decision in the recovery process.
The cost of appraisals is not part of the casualty loss. These expenses are deductible as “Miscellaneous Itemized Deductions” on Schedule A of Form 1040 for personal losses and as business expense for trade of business losses and rental property losses.
There are limitations as to the deductibility of personal casualty losses that will affect the decision and the outcome of the loss analysis.