Saturday, May 25, 2013



(A question asked recently of this blog)

When do you report your disaster loss on an income tax return?

To claim a tax deduction for a disaster loss on a tax return you must first determine the status of all possible claims for compensation for the loss. Here is the basic question that must be answered:


The taxpayer will be faced with a complex situation after a loss. An important responsibility that we all have is that we must file a tax return each year without regard for the lack of information that exists about a disaster loss. I have met people who have experienced a disaster who had been incorrectly told that they did not have to file returns for two or four years. That is not true. Your situation is not settled and yet you have to file tax returns and report what you do know. The law requires that a loss cannot be claimed until the situation has been settled. That means that a 2012 loss may end up being deducted on a 2013 or even a 2014 tax return. There is not written on this requirement in the popular press.

Where the amount of financial compensation for a disaster loss is not clearly defined at the time a tax return must be filed a difficult situation arises for the taxpayer. The filing period, including extensions could be over nine months after the close of the tax year. Sometimes that is not enough time to settle all the claims.

Before claiming a loss on a tax return the loss must be “sustained.” That requirement appears reasonable and self evident. But “sustained” is a technical term and therefore we need to delve into it further. To be “sustained” the loss must be both “incurred” and “settled.” “Incurred” is usually simple, although sometimes it may be difficult to tie down the specific date of the loss. The specific date the loss is incurred is important. If the date is near the end the taxpayer’s tax year-end it is necessary to clearly document if your loss is before the year-end or after the end of the year. “Settled” is less definitive in its implicit meaning. This is where a “closed and complete transaction” comes into the determination.

In a major catastrophe such as a flood, insurance coverage may not cover the whole loss. But was the flood damage due to the negligence of a third party? In a fire case, a utility company was determined to have been negligent in maintaining open space that was under its control where its transmission lines were located. The taxpayer had no insurance that covered the loss, but suing the utility was viable and ultimately successful. That case was not “settled” until the suit against the utility was finalized. In cases where the suit goes to trial and a verdict is rendered for the “disastered” taxpayer, the defendant may appeal, the process can go on for years depending on the total amount of the loss. The IRS tells us that all possible sources of compensation must be exhausted and attempts must be either finalized in a settlement, a final court judgment or clearly abandoned. Hopefully, in cases where a law suit is filed, the ultimate successful conclusion will result in minimizing the financial loss or eliminate the loss. That changes the tax reporting responsibility. But if the suit is unsuccessful, the year it is finalized is the year the loss becomes deductible, not the original year it was incurred.

But what about the situation where the insurance will not fully compensate the taxpayer for the loss due to inadequate coverage? Will that shortfall in coverage be covered by another party such as the utility described above or will there be a suit against the insurance company for the inadequate coverage, possibly due to a an error in the original policy underwriting process? If either of those situations is possible, then the loss is not “settled” until the appropriate avenues of possible recovery are finalized or clearly abandoned. How do you demonstrate abandonment of a possible suit that is simply not pursued? Most attorneys will tell you “don’t write a letter to your insurance company to tell them you are not going to sue them.” On the other hand, if the insurance is the only source of recovery and the coverage is inadequate but without any possibility of policy reformation then, even though the insurance claim has not been fully paid, there is a maximum amount that will be paid, the policy limits. If there is a loss in excess of the policy limits, it could be argued that the loss in excess of the policy limits is “settled” as there is no possibility of any recovery in excess of the policy limits. The insurance policy limits not collected prior to the end of the tax reporting year will be assumed to be collectible in a subsequent period. The unrecoverable loss can be deducted. The subsequent collection of the remaining policy limits is essentially a non-event. The loss in excess of the policy limits in such a case can be used to compute the loss.

And yet we have not covered “closed and complete” in some cases. In many other blog posts I have discussed the two methods of computing a loss, the “appraisal” and “cost of repairs” methods. In those posts I warn readers to avoid the use of the “cost of repairs” method in most large losses. If the “cost of repairs” method is used, the taxpayer cannot compute the loss until the appropriate repairs have been completed. This will probably delay the deduction of the loss for a year or two.

But let’s look further at the situation without the “cost of repairs” wrinkle. What is the “cost of repairs” wrinkle? For that I refer you to the numerous blog posts on the “cost of repairs” and “appraisal” method of determining a loss.

A “closed and completed” transaction does not require a completion of the repairs (unless the “cost of repairs” loss valuation method is being used). It does require that the loss is “settled.”

Your specific situation should be discussed with a knowledgeable tax professional before taking on the responsibility of filing a return for a disaster loss.

This blog, “” has been addressing taxpayer income tax issues related to catastrophic losses for more than five years.
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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
© 2013, John Trapani, CPA,

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