Wednesday, July 16, 2008

Loss Valuation - Cost of Repairs Method

Loss Valuation - Cost of Repairs Method

Revised February 24, 2011, December 2012 and Jauary 18, 2013:
Author’s noteThis post continues to be the most popular post on this blog. When you read this post, also read the January 2013 post:


February 24, 2011: A number of viewers look at this entry, but few viewers look at a prior entry June 18, 2008, related entry “Figuring the Loss – Market Value Method.” Both should be reviewed. In fact the author generally believes that the “Market Value Method” is the preferred method. The preference is discussed in the June 18, 2008 entry.

The prior blog entry (Figuring the Loss – Market Value Method.) describes the manner of claiming a casualty loss using the market value method or Appraisal Method, requiring appraisals. There is an acceptable alternative, but it has certain pitfalls.

Instead of using an appraisal to compute the “economic loss” portion of the Form 4684, you can use the “Cost of Repairs” to compute the amount of the deductible loss. You are still limited to your cost basis for the asset lost, even if the cost of repairs exceeds your cost basis. As with the market value approach, if you decide to use the cost of repairs method, first, you must deduct any insurance recoveries for the loss from the both your cost basis of the asset lost and the computed total loss to determine if there is any deductible loss.

In fact, the IRS points out that it is not the estimated cost of repairs method, it is the cost of repairs method At:

 “FAQs [Frequently Asked Questions] for Disaster Victims - Casualty Loss (Valuations and Sections 165 (i)),”
(6/1/07) Q: A number of concerns have been raised by taxpayers and tax professionals about casualty loss valuations. While the IRS continues to research and develop specific answers to these issues, general guidance follows below.
the following response is noted: (12/15/09)
A: “…To be able to use the cost of repairs method to determine the decrease in FMV of a property, the repairs must have been made by the due date of the tax return.  If the repairs have not been made, the taxpayer should file the return without reporting the casualty loss informationAfter the repairs have been made, the taxpayer may file an amended return.” (Underlining added by author)

Because of the IRS position that the repair costs are not actually incurred, taxpayers must limit the deduction to the actual costs incurred if this method is used. An example of using this method follows:

Cost basis $100,000
Insurance recovery $ 95,000
Cost of repairs $120,000

Because the cost basis is less than the cost of repairs, the limit of deductibility is the cost basis of $100,000. Once you deduct the insurance recovery of $95,000, the deductible loss subject to other adjustments, is limited to only $5,000. In another example, the following facts are assumed:
Cost basis $150,000
Insurance recovery $ -0-
Cost of repairs $120,000

Without the insurance recovery and a cost basis in excess of the costs of repair, the deduction before other adjustments in this example is $120,000.

If a further assumption related to the above example is made that there was no insurance recovery and the homeowners did some of the repair work themselves, in order to save money, or decided against doing some of the repairs, there are additional reductions. If the homeowner actually only spent $85,000 to repair the damage, the IRS would adjust this loss down by $35,000: the difference between the cost using a contractor of $120,000 and the $85,000 that people actually spent.

The cost of repairs cannot include betterments or additions that were not part of the original asset that was damaged or lost.

Costs incurred are added to the cost basis of the asset lost regardless of those cost being repairs or betterments or additions.

Additionally, if the taxpayer decides to replace the property with another property and not repair the property, then the “Cost of Repairs Method” would not be used.

The two methods, “Cost of Repairs Method” and “Appraisal Method” will not likely result in the same economic loss amount. That is not a problem.

While the “Cost of Repairs Method” appears easier to apply, the restrictions place another type of burden on the asset owner that will most likely make it inappropriate for many major catastrophic loss situations.

All rights to reproduce or quote any part of the chapter in any other publication are reserved by the author. Republication rights limited by the publisher of the book in which this chapter appears also apply.


Certified Public Accountant

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This material was contributed by John Trapani. A Certified Public Accountant who has assisted taxpayers since 1976, in analyzing and reporting transactions of the type covered in this material.  
Internal Revenue Service Circular 230 Disclosure
This is a general discussion of tax law. The application of the law to specific facts may involve aspects that are not identical to the situations presented in this material. Relying on this material does not qualify as tax advice for purpose of mounting a defense of a tax position with the taxing authorities
The analysis of the tax consequences of any event is based on tax laws in effect at the time of the event.
This material was completed on the date of the posting
© 2008, 2011 & 2012, John Trapani, CPA,

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