PERILS OF DISASTER TAX REPORTING ERRORS
Casualty reporting errors on tax returns often turn out to be
costly. … A disaster after the disaster! Why do they occur?
Many people who experience a catastrophic event face their
circumstances with quiet resolution. They just want to move on. The tax
reporting is not their first or second concern. These events often result in
the destruction of a home or a source of business income. Beyond their facade
of strength is often a person in psychological shock, a world shattered. People
who experience a catastrophic event are vulnerable and need to rely on
professionals who can assist and guide them through the recovery process. They
have to make decisions while they are in a state of mind that most people in a
comparable situation would be cautioned to refrain from making these major
decisions until they are in a better psychological place.
Unfortunately, they must make these major decisions quickly.
Family structures are often at risk, living conditions must be addressed. For
businesses, customers could be lost. There is a need to return the family
(personal and/or business) to pre-event conditions as soon as possible. But
usually, it is never the same.
The decisions involve significant assets. The emotional
investment in the destroyed assets may be greater than the financial
investment.
A methodical pre-planned process is best. If there had been
good pre-planning full recovery might be possible, but usually that is not the
way it happens. A home is the center of family life, I know from personally having
experienced the 1994 Northridge Earthquake near its epicenter. Since then it
has been a goal of this tax professional to provide people who experience these
traumatic physical losses an unbiased source of income tax information to
assist those affected in enduring the process of recovery.
The recovery process is like a three legged stool. The legs
in the recovery stool:
1 Settlement of insurance claims,
2 Physical and
emotional recovery, and
3 Dealing with the income tax
consequences.
From my own experience of dealing with the post-event
responsibilities after a large-scale disaster, I know that the first two legs
are the ones that need to be handled on a priority basis. The tax consequences
cannot be ignored as; but they must be acknowledged early on in the process. Delayed
attention may create major tax liabilities that could otherwise be affected.
Tax benefits could be lost or impact the recovery finances. Tax returns must be
filed annually; there is no provision that relieves taxpayers from filing tax
returns during a protracted recovery process. No exclusions or unusual delays
are permitted for taxpayers who experience a catastrophic loss.
Most topics I write about discuss the positive ways to deal
with these matters. There have been two articles that deal with errors in tax
reporting:
“Why can’t it just be
done right the first time?”
“Can the IRS make a
mistake?”
While the relevant sections of the Internal Revenue Code dealing
with these matters are considered “relief provisions,” with compassionate rules
that favor the taxpayer and not the collection of taxes, that does not mean
that taxpayers cannot “mess up” and unwittingly incur significant tax
consequences. Getting tax preparation assistance from someone who does not have
a comprehensive understanding of the tax rules for these situations can also
lead to problems. Attending to the tax consequences must be addressed starting
on day one. Meet with a knowledgeable tax professional to determine and develop
a process for recovering that includes maximizing the overall available tax benefits
and avoids the pitfalls.
The Internal Revenue Service rules for the deductibility of a
casualty loss include specifying what happened in order to claim a loss and defines
the documentation required to support the finality of the deduction. When a
Disaster is Declared at the federal level, then as tax professionals, we know
that it is a casualty under the Internal Revenue Code and it qualifies as an
involuntary conversion if a gain arises. Yet, two conditions must be met to
claim a casualty loss:
The event (fire,
flood, tornado, earthquake…) has occurred and
It is a “closed
transaction.”
Once those two conditions have been satisfied, a computed
loss has been sustained. Then the loss is deducted in the year it is sustained.
It can be complicated to verify what is meant by a “closed transaction.”
Generally, that means that the insurance claim process is finalized. This does
not necessarily require that all the insurance funds have been disbursed. It
does mean that the taxpayer has identified all the proceeds that will be
collected and all the sources such as third parties who were negligent, has
settled any claims. Sometimes third party responsibility does not come to light
until after a tax return has been filed. That creates an adjustment in a
subsequent tax year when the third party claim is settled.
Here is a list of income tax return errors created by
taxpayers, but mostly created by inexperienced tax professionals.
Most of the errors generated by professionals seem to arise
out of a misplaced sense of compassion. They want to create tax refunds for
their clients so the clients can increase their chances of recovering from the
event. But they don’t see how that decision may become a second disaster two or
three or more years later when those tax refunds have to be paid back, often at
twice the original benefit that was received. Why? The original tax benefit was
received at a low tax rate and the repayment, by the very nature of the
calculation, is at a much higher rate.
It is important to understand the difference between the
receipt of proceeds and the taxation of those proceeds. Some tax professionals
see the receipt of funds after the initial settlement process as automatically
taxable. This is not necessarily the outcome.
A taxpayer had a small
loss as a result of casualty deduction. Several years later, after a third
party was identified and ultimately paid large amounts to those who lost their
assets in the original disaster. The CPA made a cavalier decision to have the
taxpayer pay tax on 100% of the proceeds that they received from the third
party litigation, without regard to the underlying substance of the claim. The
result was that the CPA caused the taxpayer to overpay taxes on the proceeds by
over $50,000. The IRS agreed that the taxpayer had overpaid taxes and refunded
the taxpayer the overpayment after an in-depth office audit of the claim.
In one recent case a
taxpayer “saved” approximately $18,000 in taxes over a four year period from a
major loss that was carried forward for several years. But, the taxpayer was
facing a reversal of those “benefits” that would involve tax liabilities of
over $47,000, thus paying back more than 2.5 times the original tax refunds.
This was all due to a tax professional not asking the right questions and
making large errors in the preparation of the original loss deduction
statement. Additionally, the tax professional did not review the possibility of
the recovery of the loss or the actual benefit the loss deduction was
generating. (In this case the tax preparer sent the taxpayers to me once the
loss reversal was brought to her attention.)
Over the past several years I have seen several repetitive
errors with results similar to that described in the last paragraph. Some can
be corrected at a price and some are unfortunate mistakes that cost the
taxpayer dearly and have long-term consequences:
Here are errors where the initial tax deduction was claimed
that should not have been claimed.
EXPECTATION
of INSURANCE PROCEEDS
Casualty losses have
been claimed that do not take into consideration the realistic potential of
additional insurance reimbursements. In some cases additional, undisclosed
insurance proceeds have actually been received prior to the return being filed
and yet the insurance proceeds are ignored or under reported. Such an error can
change a loss to a gain with drastic implications for taxpayers.
A loss “flipping” to a
gain is not a terrible outcome. The gain can be reported as an involuntary conversion,
deferring the gain. Additionally, if the gain relates to a primary residence,
up to $500,000 of gain might be subject to total exclusion. But, the computations
must be made and the results reported properly on a tax return.
UNDERSTANDING
INSURANCE COVERAGE
In some cases the
extent of the potential insurance recovery was not adequately analyzed.
Expected proceeds were reported that were unrealistically low. This resulted in
claiming a casualty loss deduction that subsequently was required to be
reported as income. This can be a financial hardship, (Also see the entry in
blog [www.AccountantForDisasterRecovery.com]: “Don’t Rush to Deduct” for a
detailed discussion of this type of situation.
TIMING the
REPORTING of a LOSS
If there is a
deductible loss, generally, it is deductible in the year the loss event
occurred. Under “disaster” situations the loss can be deducted on a return for
the year prior to the year of the actual loss in some instances. For casualty
losses, it is rarely deducted in a later year. Yet I have seen losses deducted
in the wrong tax year. This is an error and requires a correction. If the loss
is not “settled” in the year of the loss event, it may be necessary to delay
the deduction to a subsequent year.
DETERMINING
COST BASIS
“Cost Basis” is an
important component in determining a possible casualty loss deduction.
Generally, “Cost Basis” is the amount originally paid for the asset lost. Fair
market value (at the date of the event) might be higher or lower than purchase
cost. A lower fair market value (at the date of the event) amount, called
“Adjusted Cost Basis,” substitutes as the cost when fair market value has
declined for personal use assets. Generally, “personal contents” or vehicles
are not worth the original purchase cost. Although items like antiques, and
artwork may not decline in value.
“Cost Basis” is not
the fair market value shown on a recent appraisal used to refinance the home.
The erroneous use of an appraisal value can lead to an inflated (overstated)
cost basis. That inflated amount can generate an excessive, unsupportable loss
claim.
For personal use real
estate, the land, land improvements and structures are considered as a single
“integral unit” by the IRS. To demonstrate what that means, assume twenty years
ago a lot was purchased for $300,000 and a home and landscaping were added at
an additional cost of $350,000 for the home and $50,000 for the landscaping. A
total investment of $700,000 is the cost basis. At the time of the casualty
loss that destroyed all of the structures but none of the landscaping, the
property was valued at $1,000,000. After the casualty, the remaining land and
landscaping had a value of $400,000. The economic loss was $600,000 ($1,000,000
less $400,000). The deductible loss would be $600,000 as that is less than the
total $700,000 cost. After the loss there is a remaining cost basis for the
land and landscaping of $100,000 ($700,000 cost less $600,000 loss). The
inclusion of the land and landscaping cost is allowed for personal use real
estate even though the loss computation results in $250,000 of the original
land and landscaping cost being written off as part of the loss.
VALUATION
OF ASSET BEFORE and AFTER the CASUALTY EVENT
The two values of fair
market value (immediately before and immediately after the loss event), seem to
be taken very “lightly” by some tax professionals. The importance of these
amounts cannot be overemphasized. These amounts will have an important impact
on the overall loss computation. There are two accepted methods of arriving at
the amounts. However, when the Form 4684 is filled out to report the loss in a
tax return, there is no declaration required as to the method that was selected.
The method selected is only understood when supporting documentation is
presented to a tax examiner. Much of the documentation should be included in
the tax return; with e-filing, this supporting material would be a PDF
attachment. It may be too late if the material is not included in the e-filed
return. At that point the tax examiner may conclude that while one method was
intended to be used, the documentation does not adequately support the
deduction method. In fact, the IRS does not select the method used, but, if the
method intended is not supported by the facts, the IRS will then make the
selection based on what the facts appear to support. Usually, that means
reducing the deduction. Here are the rules and how they are often violated:
GENERAL
The difference between
the two amounts (“value immediately before the event” and the “value
immediately after the event”) is the “economic loss.” The deductible loss is
the lower of the “economic loss” or the “actual cost basis” of the property
lost. In both instances the results are reduced by the amount of the insurance
proceeds realized or estimated to be realized. If the “loss” less the insurance
proceeds is greater than zero, there is a deducible loss. For personal losses, the
loss will be reduced by $100.00 and 10% of Adjusted Gross Income. Adjusted
Gross Income for individuals is the amount on the bottom of page one of Form
1040.
To arrive at the two
amounts (“value immediately before the event” and the “value immediately after
the event”), there are two acceptable methods described in the tax law. Case
law acknowledges that it is not likely that these two methods will generate the
same result.
“COST of REPAIRS”
VALUATION METHOD (Not preferred by this tax professional)
In some cases the
“cost of repairs” may be a useful method to arrive at a possible loss. Using
this method requires that you “back” into the “value immediately after the
event.” The reason is that the cost of repairs is subtracted from the “value
immediately before the event” to arrive at the “value immediately after the
event.”
That sounds simple.
Not necessarily though. Some people think this method avoids the necessity of
getting an appraisal. For a small loss being charged against a large cost basis,
the cost of repairs might be used. For most insured losses, the insurance will
probably cover the repairs and thus there will be no deductible loss. But for
most personal residence disaster losses the lack of an appraisal does not work.
The lower of the appraised value before the loss or the cost basis of the
property is the upper limit of the possible loss. In the recent real estate
market, it was quite possible that the “value immediately before the event”
could be less than the cost basis.
PROBLEM
A major problem in the
execution of the “cost of repairs method” is actually embodied in its name: the
“cost of repairs method.” It is not the “estimated
cost of repairs method,” or “the estimated cost to be spent to fix and improve
the property damaged method.” The costs
must actually be incurred prior to claiming the deduction and only those costs
required to bring the property back to its pre-event status will be considered
in the computation of the cost of repairs. It is unlikely that the repairs are
an exact replication of the damaged property. The tax law specifies that only those repair costs that return the
property to its prior condition may be used in the computation of the cost of
repairs. Deciding not to replicate some portion of the original property
reduces the potential deduction. Making an alternative repair that is an
efficient, but not a duplication of the original feature or structure can also
be a problem as it does not return the property to its pre-event condition. In
many cases, no repairs are made. Instead the taxpayer acquires a replacement
property. If no repairs are made, no deduction is allowed.
It is possible that
the repairs are not completed prior to the due date for filing the return. This
situation results in the return having to be filed without the deduction. A statement
should be included in the original return addressing the general facts of the
loss without claiming a loss. Once the costs have been incurred and tallied,
the return for the year of the loss cannot be amended to report the loss; the loss is deducted on the return for the
year the repairs are completed, that is when it is “settled.” became
settled. n most cases this process eliminates the ability to claim a loss on
the return for the year prior to the year of the loss that is allowed in
federally declared disasters. Additionally, the potential tax reductions are
not available to the taxpayer to help pay for the rehabilitation of the
property until later.
“APPRAISAL” VALUATION
METHOD
The “appraisal method”
is the better method to use; it does not have the problems of the “cost of
repairs” method. But, for real property the “appraisal method” requires two
actual appraisals by a qualified appraiser. Both appraisals can be incorporated
into one appraiser’s report. The appraiser would provide the value immediately
before and immediately after the event. In the case of major destruction, there
may be problems for the appraiser to be able to arrive at opinions on the value
after the loss. There may be temporary losses in value due to “temporary buyer
resistance” that cannot be included in the value of the damaged property after
the loss event. A qualified professional will have the expertise to complete
the assignment.
I have prepared a
report that is available to appraisers that discusses the unique requirements of
“disaster appraisals” to conform to IRS rules.
For personal property,
the appraisal may not be important unless there are high value items that were
lost or damaged.
PROBLEM
A problem arises when
the tax professional does not instruct the taxpayer to secure the requisite
appraisals. In that case the tax professional may simply pull amounts for the
two values “out of the air” without actual substantiation – a tax professional
is not an appraiser. This “expedient” action forces the taxpayer into the “cost
of repairs” method but without the required support. As explained above the
cost of repairs method requires certain performance and other documentation.
Since the repairs have not been completed and the amount of the loss probably
has no relation to the actual qualified cost of repairs, the taxpayer has
significant tax reporting risks that have been created by the tax professional.
The taxpayers may have lamented that they could not afford the cost of the
appraisals and the tax professional wanted to help the client. Even though the
tax professional has the best of intentions, the worst of results looms over
the head of the taxpayer, loss of deduction, penalties and interest as well as
a difficult IRS examination process.
One other appraisal
problem looms over the taxpayer. How do you get an appraisal of a piece of real
estate that prior to the disaster when the property is completely destroyed in
the disaster? Sometimes photos are available. Maybe the appraiser has had prior
recent experience with the property. Maybe there are county building permitting
records that might be useful. In most cases the appraiser will be able to
surmount the difficulties.
ADDITIONAL
PROCEEDS
Sometimes, to assist a
client, the tax professional will ignore or fail to discuss with the client the
possibility of receiving additional compensation for the loss. The potential
additional receipts may be sought from the insurance company or a third party
who is believed to have some culpability for the loss. As pointed out above,
the loss deduction is allowed once it is “sustained.” To be “sustained” the
loss must have occurred and it must be a “closed transaction.” The transaction
is closed only once all claims for compensation have been resolved or clearly
abandoned.
Here are more details on these situations.
INSURANCE
POLICY “REFORMATION”
There are several
possible situations that provide additional proceeds in the process of settling
an insurance claim.
There are various
situations where the insurance company may agree to “reform” the insurance
policy. Generally, reformation means retroactively changing the policy coverage
to increase the benefits available to the policyholder either by increasing
coverage or applying the benefits of a higher quality policy. Reformation could
arise as a result of a clear determination that the policy limits or
endorsements listed on the contract declaration page were unrealistic or
incorrect based on what the policyholder thought was included and the owner
apparently had no reason to exclude such coverage. To achieve the reformation,
it might require a negotiation marathon by the policyholder, or it may require
the assistance of an attorney. If this process is commenced, the transaction is
not closed until the case is settled or clearly abandoned.
LAW SUITS
– INSURANCE or OTHER NEGLIGENT PARTIES
In some instances it
may be necessary to file a lawsuit against the insurance company or a third
party believed to be responsible for the loss. The settlement may be consistent
with the property loss and therefore treated as additional insurance proceeds.
Or, the settlement or court judgment may be for damages that have nothing to do
with the loss covered listed in the insurance policy or the actual damages and
necessitate further analysis to determine if they are separately taxable or
part of the property claim.
In all situations, an
understanding of the full potential for proceeds may not be known at the time
of filing a tax return. However, if negotiations are still in process or
consideration is being given to filing a lawsuit, then the claim is not
settled, the transaction is not closed.
The opposite may be
true also, the original coverage may have been correct, but it turns out to be
inadequate. The claim is in process but all proceeds have not been paid. The
policyholder believes that all policy limits will be paid, but that still
leaves a loss that will not be paid by insurance. In that case it is not
unreasonable to deduct the remaining loss in excess of the coverage even though
the insurance proceeds have not been fully paid. It is imperative in these
situations to understand all available insurance coverage limits and assume
that all of these limits will be paid. Once the policy limits are believed to
be paid and there are still losses, those losses can be deducted, while waiting
for the collection of the unpaid limits.
“DEEMED
ELECTION TO REPLACE”
(But no
deemed election to select replacement)
Sometimes the taxpayer
decides to “hide” the insurance proceeds. The typical statement that is
uttered: “The insurance company is not issuing a Form 1099, no one will know
that I have received this (very large) check” (except that the deposit appears
in the bank account). In such a case the “Deemed Election” comes into play.
Here is the “compassionate
side” of the regulations: The “Deemed Election” is a special, but dangerous
relief provision in the IRS regulations. If, as a result of the claim process
and a determination of the cost basis of the property lost, there is a gain
(the proceeds exceed the cost basis of the property lost), the taxpayer /
policyholder has two choices.
The taxpayer may make
an election to defer the gain and accept the reporting responsibilities that
come with that election including complying with the replacement process.
Or, the taxpayer can
report the gain as taxable income and pay the tax.
But what happens if
the taxpayer does neither?
The IRS regulations
state that in a case where nothing is done, the taxpayer has made an undeclared
election to defer the gain.
It is referred to as a
“deemed election” as the taxpayer is deemed to have made the replacement
election when no actual election is made. This article does not have enough
room to go into details, but this “deemed election” is very dangerous as
taxpayers who depend on it (knowingly or unknowingly) make additional
assumptions that the IRS does not agree to in the regulations. This “deemed
election” can result in a delayed financial disaster if it is relied upon. If
the “deemed election” is used, subsequent corrective measures must be taken to
eliminate risk for the taxpayer. Sometimes those corrective actions may be
barred by statute or time limits expiration
The “deemed election”
is a possible first step relief for taxpayers who decide not to tell the IRS anything
about the transaction. But it has numerous dangers. If there is a gain, make a
definitive decision, either specific deferral of the gain or pay the tax, do
not rely on the “deemed election.”
Most of what has been discussed in this article is not covered
in any publications distributed by the IRS as aids for taxpayers who want to
prepare their own “disaster tax returns.” Most tax professionals do not have
the time to learn all the intricacies of disaster income tax reporting. If you
need assistance, discuss with the tax professional the depth of their
understanding in this area of the tax law.
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.
JOHN
TRAPANI, Certified Public
Accountant
2975 E. Hillcrest
Drive #403, Thousand Oaks, CA 91362
(805)
497-4411 E-mail John@TrapaniCPA.com
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. 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 updated
on February 7, 2017
© 2012 and 2017, John
Trapani, CPA
