The tax code provides two acceptable methods of computing the value of a casualty loss, the appraisal method and the cost of repairs method. The appraisal method is generally the preferred method, especially for large losses. Over the years, the most read page deals with the cost of repairs method of valuing a loss. Since I am generally opposed to its use, I hope that people will find this entry first before proceeding to examine the cost of repairs method in detail.
Here are the IRS rules, straight out of the regulations:
Federal Income Tax Regulation 1.165-7 (2)
Casualty Losses - Method of Valuation
(i) In determining the amount of loss deductible under this section, the fair market value of the property immediately before and immediately after the casualty shall generally be ascertained by competent appraisal. This appraisal must recognize the effects of any general market decline affecting undamaged as well as damaged property which may occur simultaneously with the casualty, in order that any deduction under this section shall be limited to the actual loss resulting from damage to the property.
(ii) The cost of repairs to the property damaged is acceptable as evidence of the loss of value if the taxpayer shows that (a) the repairs are necessary to restore the property to its condition immediately before the casualty, (b) the amount spent for such repairs is not excessive, (c) the repairs do not care for more than the damage suffered, and (d) the value of the property after the repairs does not as a result of the repairs exceed the value of the property immediately before the casualty.
The appraisal method is actually reasonably simple, two appraisals and a recognition of the exclusion of the affects of temporary buyer resistance as stated in the regulation: “recognize the effects of any general market decline affecting undamaged as well as damaged property which may occur simultaneously with the casualty, in order that any deduction under this section shall be limited to the actual loss resulting from damage to the property.”
What is buyer resistance? In a large disaster, immediately after the event, people who would otherwise have sought to purchase in the area stay away. This causes prices to be depressed due to a lack of buyers. The buyers that do show up are looking for bargains. After a reasonable amount of time, the buyers come back. Where home has been destroyed and the only thing left is the land, the appraiser might look to see what similar vacant land was valued at prior to the event to determine a post-event value. There is one other adjustment that the appraiser should consider. This one will increase the loss by reducing the post-event value. The additional item is the debris that needs to be cleared off the property. The IRS clearly states that the actual debris removal is a replacement cost, not a part of the casualty. However, the presence of that debris is certainly going to affect the value of the property and should be included in the appraiser’s valuation analysis.
On the other hand there may be situations where the cost of repairs method may apply. But it has numerous requirements that make it unwieldy at best and impossible at worst. Let’s look at each one:
I am going to discuss the four requirement in the order of how they impact the way it can be used.
(b) the amount spent for such repairs is not excessive,
The key word in this requirement is “SPENT.” The loss cannot be determined until the repairs have been completed. And then the loss is deducted in the year that the repairs have been completed. That could be two or three years later. One of the biggest values of the deduction is to provide some additional case, through tax refunds, to pay for the repairs. If the repairs must be completed first, then the funds are not available. That is why I put this one first.
(a) the repairs are necessary to restore the property to its condition immediately before the casualty,
(c) the repairs do not care for more than the damage suffered, and
(d) the value of the property after the repairs does not as a result of the repairs exceed the value of the property immediately before the casualty.
These requirements mean that in computing the repair cost, only those costs that get the property back to its prior condition are included. Not that does not mean that if you had green paint, that you must use green paint again. But it does mean that if you wallpaper a room that was painted, the wallpaper is not part of the loss computation. Of course, adding a room, replacing tile with granite are also not acceptable.
Because repairs are never made to duplicate what was there before the loss, these rules are hard to comply with.
Where the loss is partial, but still major damage, and the property is repairable, the question arises: how does an appraiser value the property immediately after the event? There have been several cases where the appraiser uses an estimate of the cost of repairs that has been provided to him/her to arrive at a post-event value. My favorite case is TCM 1981-231 (May 7, 1981) Paul Abrams and Melba Abrams, et al.