P of R # 2

7          NO GAIN OR LOSS
8          A LOSS

The potential and actual tax consequences must be understood prior to making any replacement decisions and the process afterward. There is some flexibility in making changes to decisions later, See “Things Can Get Worse” section 15.

It is possible that the initial analysis results in no gain or loss. Yes that is possible. If insurance is adequate, the loss was not total and the cost basis is the result of a recent acquisition of the property.

Even it there is no gain or loss, it is advised that the following information should be part of the disclosures included in a tax return related to a catastrophe:
  • The type of casualty and when it occurred (including, if available, the FEMA identification number).
  • The date of the loss.
  • That the loss was a direct result of the casualty.
  • The information relates to the return for the taxpayer who owns the property (or the taxpayer is leasing and is contractually liable to the owner for the damage.)
  • The city, county and state in which the loss event occurred.
  • Any replacement costs incurred, appropriately detailed.
  • Cost basis of property damaged.
  • Insurance proceeds received or expected to be received.

If the gross loss does not exceed $10,100, and the taxpayer’s adjusted gross income is $100,000, no deduction would be allowed. The facts should be disclosed in the return. The above items should be reported.

Odd as it may seem, there are other possible ways to have neither a loss nor a gain. It may even be possible that there is a gain, but due to the application of available exclusions, there is no realized gain. If the cost basis of the property is close to the insurance recovery and the insurance is reasonably adequate, there is a good chance, there will be no loss or gain realized for income tax purposes.

If there is a gain, but the residence qualified as a complete loss, triggering the Internal Revenue Code section 121 exclusion of gain, $250,000 for the taxpayer and $250,000 for the spouse. A gain of less than $500,000 for a married couple eliminates the gain, but it results in no gain or loss. It does require the filing of a complete statement to claim the exclusion. The above items should be reported.

When computing a loss the cost basis that is used is based on the “adjusted cost basis” as described above. Because of that, an initial loss based on actual cost basis may evaporate when the actual cost basis is replaced with the “adjusted cost basis.” If that computation turns into a gain using “adjusted cost basis,” there would be no gain to report and no loss.

8      A LOSS
There are instances where it is necessary to determine who is entitled to claim any deduction for the loss.

When to deduct a loss:
In order to claim a deduction the Code requires that the loss must be sustained. To be sustained, the loss must have occurred and the claims process, settled. There is some vagary in the meaning of settled. Assume a loss of $1,200,000. The maximum possible insurance coverage that is available to pay for the loss is $800,000. The insurance company has paid out only $200,000 by the time that the tax return is due for the year in which the loss occurred. There is every likelihood that the balance of the policy limits will be paid. There is no certainty that any loss in excess of the limits will be recouped from insurance or that any claim for additional loss is even possible. Under this situation, it may be reasonable to take the position that the loss of $400,000 in excess of the policy limits of $800,000 has been settled.

Without going into a long analysis, if the loss is $150,000 and the insurance will only cover $100,000, then it can be argued that $50,000 is sustained even if the claim process is not yet completed. If the insurance company pays only $95,000 on the claim, then an additional $5,000 would be deductible in the year that the $95,000 is finalized.

The loss and cost basis are reduced by insurance proceeds. The loss can be determined using one of two methods discussed below.

Documenting a loss is accomplished using the “Appraisal Method” or the “Cost of Repairs Method.”

For the “Cost of Repairs Method” only the cost of the repairs necessary to return the property to its pre-event condition is compared to the Adjusted Cost Basis of the property damaged; the lower of the two amounts is the loss. Using the Cost of Repairs Method, the cost of removing the debris would be one of the amounts leading to the total cost of repairs. The deduction can only be taken once the repairs have been completed. If the repairs are completed in a year subsequent to the year of the event, once they are completed, the taxpayer would file a return for the year of the of completion, claiming the loss. The drawback of the Cost of Repairs Method is that the repairs must be made and only those repairs that return the property to its pre-event condition are permitted to be included in the computation of the loss. Any improvements or betterments, either required or elective, are not allowed as part of the cost of repairs calculation of the loss.

Selecting the “Cost of Repairs Method” does not alleviate the need for an appraisal. The value immediately before the event must still be determined to establish the lower of actual cash investment or appraised value for determining the adjusted cost basis before the loss event.

Using the Cost of Repairs Method also limits the taxpayer from reinvesting the insurance funds in a separate replacement property to qualify as replacement of the damaged property. “Betterments” can and should be incorporated into the repair, but the cost of the betterment do not qualify as a cost for computing the amount of the loss. In some cases, a repair may be called for that is demanded by the building code, but does not duplicate the original construction. Even though it may cost the same as returning the property to substantially its original configuration, it will not count as the IRS will likely view it as a disqualified improvement.

Where a taxpayer has made a decision to epoxy a cracked slab and use the cost savings to upgrade a kitchen, the upgrade would be excluded from the computation of the allowable loss. Since the concrete slab will not be replaced, its cost of replacement included in the insurance claim is not part of the loss computation either.

Under the law the details of the repairs used to quantify the loss using the “Cost of Repairs Method” must be traced to the completion of the repairs within a reasonable period of time after the event, considering the completion of the insurance claims process.

All of the restrictions inherent in the Cost of Repairs Method disappear when using the “Appraisal Method” for determining the loss. Under the “Appraisal Method,” the taxpayer simply gets two appraisals prepared by a competent, qualified real estate appraiser. The first appraisal computes the value immediately before the loss event occurred. The second computes the value giving effect to the fact that the loss has occurred.

The second appraisal should specify and include the detrimental effects on the fair market value due to the debris that is present after the event. It should also specify that i

“The post-event appraisal does not give effect to any temporary buyer resistance that may be impacting the market immediately after the event.”

The appraiser need not compute the difference between the two amounts.  To arrive at the Appraisal Loss the requirements are entered on Form 4684. The Appraisal Loss is compared to the “Adjusted Cost Basis,” discussed below. The loss is the lower of the Adjusted Cost Basis or the Appraisal Loss. The loss and cost basis are reduced by any applicable insurance proceeds.

Using the Appraisal Method allows the taxpayer to use insurance funds for the repair and improvement of the damaged property or the acquisition of a replacement property. (The insurance contract may impose separate limitations.) There are no income tax limitations placed on the location of the replacement property. It does not even have to be located in the same state.

Expert personal property appraisers may be able to approximate the original cost and pre-event value of some contents.

The taxpayer may think that providing the appraiser with a copy of the scope of loss will assist the appraiser in determining the value of the property after the event. The cost of repairs is not necessarily relevant to the appraiser’s valuation analysis for the pre-event value and the destroyed structure is irrelevant to the land value after the event. The appraiser will make an independent determination of the value of a partially destroyed structure.

The risk of providing the scope of loss to the appraiser is that if the appraiser includes any reference directly or indirectly to the scope of loss, while the taxpayer has selected the “Appraisal Method,” the IRS, in an audit may incorrectly assert that the “Cost of Repairs Method” has been selected. The IRS has lost on this allegation. The courts allow the appraiser to use his / her expert judgment to arrive at the estimate of value. But while the IRS has lost on this scenario that does not mean that the auditor you are facing will know that. It potentially adds an additional item that must be dealt with in an audit that can be avoided.

Determining a loss
If there is a loss, the taxpayer must take care in determining the loss including which method of computation to use. Determination of the loss is based on one of the two methods of computation. The choice of method is left to the taxpayer, although the IRS has been known to question the outcome and attempt to use another method. Generally, the taxpayer’s choice has been upheld if it has been properly supported. The IRS will prevail over taxpayers who have been loose with the accumulation of proper supporting evidence. The two methods of determining the amount of the loss are quite different. The Appraisal and Cost of Repairs Method s will not provide equivalent results. In fact, it is likely that they will result in quite disparate amounts.

The loss computed using either method cannot exceed the adjusted cost basis of the property.

Reporting a Loss – FORM 4684
It must be determined in what tax year will the loss be reported on a tax return. Assume the loss occurs near the end of the year. The claims process can be complicated and may extend past the end of the year subsequent to the year that the event occurred.

Once the basic amount of the loss is determined, there are two adjustments that reduce the amount of the tax deduction. The first is that $100 for each event during the year is excluded. The amount of income that appears at the bottom of page one of the Form 1040 income tax return is called “Adjusted Gross Income” (AGI). The second adjustment requires that 10% of AGI must be deducted from the total of all casualties reported for the year. If the pre-adjustment losses total $50,000, all from one event, and AGI for the year is $100,000, the deductible loss will be $39,900 ($50,000 less $100, less 10% of $100,000).

The IRS has a number of useful booklets for taxpayers who experience a catastrophic physical event. The IRS has combined a number of these separate publications in two publications,
2194 for individuals and 2194b for businesses.
The booklets can be accessed on the IRS website at www.irs.gov.

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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Thousand Oaks, CA 91362

(805) 497-4411       E-mail John@TrapaniCPA.com

Blog: www.AccountantForDisasteRrecovery.com

                           It All Adds Up For You                     


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
© 2011, 2012 & 2013, John Trapani, CPA,