Disaster Recovery Income Tax Advice: February 2015

Tuesday, February 3, 2015

SO MANY WAYS TO ERR…

WHEN A DISASTER STRIKES… BE CAREFUL… DON’T FORGET YOUR IRS REPORTING responsibilities

BEWARE OF THE PITFALLS

SO MANY WAYS TO ERR…

Many articles in the popular and professional media summarizing the basics of the income tax implications of a casualty loss no more informative than IRS Publication 547, “Casualties, Disasters, and Thefts”.

The basic concepts for claiming a casualty loss are not very difficult. However, the cliché, “the devil is in the details,” is true. The ways that the execution of compliance can result in major errors are vast, and potentially expensive, causing disastrous unnecessary tax liabilities, or tax audit costs. These are not often addressed. It appears to be an “orphan” area of the public tax law literature. Most CPAs have more clients with Sec. §1031 transactions than casualty losses beyond an auto collision. John Trapani, CPA, has written extensively on many of these potential problem areas on a blog: “www.AccounantForDisasterRecovery.com.”

Beyond the basics…

How can a taxpayer magnify the resulting financial disaster by making mistakes not attending to the basics and ignoring details? The amounts in these situations are often the largest numbers that taxpayers will ever report on their tax returns. Both the taxpayer and tax professional should attend to the basics and details. It is understandable that the taxpayer wants to move on and get the home back in livable condition; that is where the tax professional must provide guidance to tie down the details protecting the clients in the event of a possible IRS attack.

This article introduces a series discussing a areas where taxpayers need to spend attention to avoid costly erroneous results and audit risks.

The Form 4684 may seem difficult to taxpayers, most CPAs look at the form through their tax prep software and see only four items for each loss category of assets damaged or destroyed. The first reality is that the problems start in the Code and Regulations. There are vague phrases and definitions that are simply passed over. The first step to success is understanding the relevant details of the Code and Regulations.

MOST ERRORS RELATE TO THE FOLLOWING AREAS:

Here is a list of areas where taxpayers unknowingly and commonly make costly errors.

1. Documentation

o Cost basis of major assets lost or damaged

o Proper segregation of insurance proceeds

o Valuation mistakes

2. Making elections to defer gain or not to report gain

3. Insurance coverage claims in-process

4. Decision to report a loss

5. Timing, when to deduct a loss

6. Replacement qualification and reporting errors

7. Changes in circumstances and changes of mid

8. Exclusion for “unscheduled” personal property proceeds in federal declared disasters

9. Differentiating between scheduled and unscheduled personal property

10. “Common Pool” of funds for personal use real property insurance proceeds

11. “integral nature” concept for “Personal Use Real Estate”

12. “Single Identifiable Property” for non-personal use real estate

13. Segregation of damaged and undamaged property

14. Responsibility to timely file tax returns during recovery period

But there are more…

Over the next weeks these issues will be examined. In this forum, due to the intricacies of the format, not all of the problem areas can be addressed.

Before we can look at these areas, there are several issues that affect the overall understanding of the casualty / involuntary conversion area that need to be covered first.

VAGUE PHRASES

To start, the problem is the vague phrases in the Code. At first blush, they seem reasonable, but then as you look deeper, it is apparent that there are pitfalls. In the case of the casualty / involuntary conversion Code sections, there are several large vagaries that we have to live with. It is important to recognize that the Code sections that we depend on to ease the financial blow of a disaster are in place because of the recognition by Congress for the need to provide such relief, recognition that goes back to at least 1867. We have to acknowledge that these Code sections are there due to “Legislative Grace.” These sections include some historic language that create interpretation problems in practice. To start, even the IRS acknowledged that §165(c)(3) has a very vague phrase that shows up in the post 16^th Amendment code: “Fire, Storm, Shipwreck or Other Casualty.” IRS Rev. Rul. 72-592 notes the historic lack of interest on the part of Congress to clarify the term “other casualty:” No change in the last 43 years.

The provision allowing this deduction for losses from “other casualty” has been part of the Federal tax law since the enactment of the Revenue Act of 1916. However, there is neither statutory definition of the term “other casualty,” nor legislative history expressing Congressional intent as to its meaning.

The courts and IRS continue to grapple with the concept.

But, in a more modern addition §165(h)(3)(C) notes that a federally declared disaster is always subject to the casualty loss Code sections. This removes the question of whether an “other casualty” must be resolved for the many federally declared disasters.

On one hand, if an event has been declared a Federal Disaster, it is clear that the event qualifies as a casualty. But an event that is not declared a Federal Disaster opens up the potential of an IRS challenge at the very root of the tax loss claim: that the loss is not a casualty. In some cases the IRS is correct as determined by the courts, and in others taxpayers havelost due to weak documentation or weak circumstances. Since specific audit results are not become published we do not know how many loss claims are torn apart in an audit without further legal pursuit by the taxpayers in the public area of a court airing. And yes, there are cases exposed in published tax court opinions that seem to have been a waste of time on the part of the taxpayers. The term “Other casualty remains contentious; one that will likely never be resolved.

Articles are currently available on the details of the several concepts where taxpayers can add to their disaster situation. Here are five topics that should be considered by every taxpayer who is recovering from a catastrophic loss:

1. WHAT IS YOUR INSURANCE SITUATION?

a. No insurance

b. Under insured

c. Adequate insurance

2. IRS Audits

3. “DEEMED ELECTION” TO REPLACE PROPERTY INVOLUNTARY CONVERTED

4. DISCLOSURE FOR “NO GAIN OR LOSS” OR “A LOSS”

5. SOME MAJOR VAGUE PHRASES

6. “VALUING” A LOSS

These topics are discussed in articles that follow (by posting date) this post on the blog.

JOHN TRAPANI assists both taxpayers directly and advises taxpayers’ tax professionals.

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.

All rights to reproduce or quote any part of the chapter in any other publication are reserved by the author.

	JOHN TRAPANI
	Certified Public Accountant
	2975 E. Hillcrest Drive, #403
	Thousand Oaks, CA 91362
	(805) 497-4411 E-mail John@TrapaniCPA.com
	Website: www.TrapaniCPA.com
	Blog: www.AccountantForDisasteRrecovery.com



	It All Adds Up For You

Tax Advice Disclaimer

Any implication of accounting, business or tax advice contained in this material is not intended as a thorough, in-depth analysis related to your specific issues. It is not a substitute for a formal opinion including a discussion or your specific situation. It is not sufficient to avoid tax-related penalties. If desired, John Trapani, CPA would be pleased to perform the requisite research, specific to your facts and circumstances and provide you with a detailed written analysis. Such an engagement would be the subject of a separate engagement letter letter that would define the scope and limits of the desired consultation services.

This material was completed on the date of the posting

A 450+ page text book is available for purchase:

DISASTER RECOVERY, Tax Benefits and Reporting Responsibilities

The book covers the tax reporting process from incident to resolution in disaster situations including descriptions of how taxpayers can run into trouble.

An APPRAISER'S GUIDE (100 pages) is also available for purchase to assist in evaluating appraisal reports and guiding appraisers in the tax law requirements to be addressed in an appraisal.

WHAT IS YOUR INSURANCE SITUATION?

WHEN A DISASTER STRIKES… BE CAREFUL… DON’T FORGET YOUR IRS REPORTING RESPONSIBILITIES

BEWARE OF THE PITFALLS

WHAT IS YOUR INSURANCE SITUATION?

This article is part of a series of articles emphasizing several ways taxpayers can be trapped by problems in dealing with the tax reporting obligations resulting from a major casualty loss event.

In order to understand which errors are possible and their impact on taxpayers, it is necessary to start with the taxpayers’ insurance situation.

Here is the simple case. Regardless of the level insurance coverage, if at the end of the tax year event, although the claim is not completely settled (not all the claim has been paid), by the time the tax return is to be filed including the post-year-end information in the computations results in a settled transaction, the outcome is final; reporting information on the tax return for the year of the event is all available, the taxpayer has a completed transaction. This does not necessarily mean that mistake cannot be made. It simply reduces the spectrum of possible errors.

But, the above is the unusual situation. If the claim is not settled by the time the return is due, the taxpayer may have to wait until the next year to report the loss. This will be discussed in detail in another article, “REASONABLE PROSPECT OF RECOVERY.” But there should still be a disclosure of the event facts know as of the end of the relevant tax filing year. That aspect is discussed under the topic: “SOME MAJOR VAGUE PHRASES” in a later post.

Insurance (or the lack of insurance) impacts the tax consequences of disaster events. The presence or lack of insurance must be considered in the overall evaluation of the loss event and its tax implications. Generally there are three possibilities.

Here are the general situations to consider:

No Insurance Coverage?

There may be situations that the loss is not covered by insurance, but it turns out was caused by some entity that may be pursued for reimbursement (a responsible third party). These situations present tax reporting concerns similar to insured losses. The an additional concern is that the third party responsible for the loss may not be evident for some time after the event; the decision to pursue a claim against that party may take several more months to conclude. In some cases, it may be difficult to find a necessary advocate to pursue the claim. Filing a return in these cases creates complications. When it comes to filing the return for the loss year the process may be in early decision stages; see “DON’T RUSH TO DEDUCT” in other articles on this blog.

Where a loss occurs that is not covered by insurance, the taxpayer has additional hurdles to cross. An event that is covered by insurance adds a level of the event being classified as a casualty because an insurance company is going to make a cash payment due to the loss (even if it is not adequate for a proper recovery). If the taxpayer simply elected not to purchase coverage, that is one thing, the Code does not require taxpayers to carry insurance for all possible events that include possible insurance coverage. But, the situation may present additional steps to determine if a “casualty” as defined by the Internal Revenue Code has occurred. For example, termite damage generally is not a casualty event since the damage occurs slowly, progressively. Similarly, drought is not usually considered a casualty. But, there are cases involving both termites and drought that have been were determined by courts to be casualties.

Where a loss occurs and is not addressed by the taxpayer, the court generally sees subsequent losses in the same area to not be deductible since the taxpayer was apparently not powerless to prevent the loss.

The documentation of the loss in these cases is extremely important. The lack of insurance removes an independent party evaluating the loss, even if the insurance company does not pay the appropriate amont.

Under-insured Coverage?

In the case of flood coverage, there is a maximum policy payout that often limits the loss recovery to an amount that is less than the total loss. In other cases, insurance may have been purchased on the basis of what premium was affordable rather than what coverage was needed. Taxpayers are not penalized by the tax law for these conditions. In many of these situations the tax consequences become apparent quicker due to the loss being so much greater than the coverage. As a result, the insurance may payout the maximum quickly leaving the taxpayer to compute the loss and possibly claim a loss.

For properties that have been held for some time the cost basis may be lower that the insurance payout. Even though the coverage is not adequate, the taxpayer has a gain with a short-fall in funds to pay for repairs.

Because of the many variables, these cases can be very difficult to arrive at how and when to report a loss or possible deferral.

Adequately Insured Coverage?

While a taxpayer may have adequate insurance, there are numerous situations where collection becomes problematic. Disagreements can arise between adjuster and property owner over the appropriate amount of reimbursement. There are cases where owners are attempting to get “pre-event” deferred maintenance covered by the insurance company and there are cases where the insurance adjuster attempts to take advantage of the owners’ lack of negotiation skills. In many of these cases where adequate insurance coveage exists, the extended collection process can be a problem for taxpayers. Where there is the possibility of not collecting the full amount of the covered loss there may or may not be resulting tax loss.

FEDERAL DISASTER AREAS

Where there is a Federal Disaster Declaration additional issues can arise.

In many wide-spread events, the insurance companies are stretched thin on providing timely adjustment services. This can stretch out the settlement process.

The taxpayer can elect to claim a loss on the income tax return for the year of the loss event or the immediately preceding year. But claiming the loss has additional issues that must be addressed. In some cases the event occurs near the end of the year and the Disaster Declaration is not announced until late in February or even into March of the following year. The decision to deduct a loss in the year of loss or the prior year becomes more stress laden. After 2005 Katrina and 2013 Colorado Flooding, the IRS extended the April 15 decision deadline to October 15. Katrina occurred in late August and the Colorado Flooding occurred in Mid-September. But Super Storm Sandy that hit in late October of 2012 and affected a number of states, but received no extension of the April 15 deadline to claim any loss on the prior year return.