Disaster Scenario

First of all, I want to send my prayers, condolences and best wishes to those in the Deep South who have been ravaged by an unprecedented series of natural disasters from tornadoes to massive flooding.  Have courage and rely on your faith and each other to get through this.

It’s probably not surprising that as a tax guy, this morning I found myself thinking about the Casualty, Disaster, & Theft Loss tax deduction that is available to taxpayers on Schedule A of the federal Form 1040.  Can it help in this situation?  Sort of.

As I often tell my clients, the Casualty, Disaster &Theft tax deduction is something I hope they will never need.  Qualifying for the deduction isn’t easy because the IRS doesn’t allow the deduction for comparatively minor losses, so qualifying means that you’ve taken a serious and really significant financial hit during the course of the year.

For openers, any loss that you might experience – such as damage from a tornado or a flood – must be an uninsured loss.  You can’t claim the deduction for losses to the extent that you are being compensated by somebody else because, at least in the financial sense of the word, you haven’t really experienced a loss.  So if replacing the hail-damaged roof of your house is going to cost $15,000 and your insurance will pay the whole thing, you don’t have a deductible loss.

On the other hand, if you experienced $20,000 in flood damage and your insurance specifically excludes flooding (and many policies do – check yours today) then you have a $20,000 loss that is potentially deductible. If your insurance only paid a portion of the damages, then the portion not covered by insurance is also a potentially deductible loss.

Potentially.

Potentially.  Because here’s the catch – you’re not going to be able to claim the whole amount.  Let’s say that your car was stolen and subsequently wrecked.  To calculate your deductible loss, you would take the Fair Market Value of your car on the date it was stolen and then subtract from that amount whatever you received from the insurance company in addition to any amount that you received from the salvage company that towed your wrecked car to the junk yard.

After you deduct the amount of any insurance compensation and salvage value, you then deduct $100 from the remaining balance (don’t ask me how or why the IRS settled on this figure) and then you deduct 10% of your Adjusted Gross Income that appears on from Line 37 of your Form 1040.

And that’s what makes qualifying for the Casualty, Disaster, & Theft tax deduction so difficult.  It’s the reduction by 10% of your AGI that will most likely take “routine” losses off the table for the purpose of receiving a tax deduction.  If your Adjusted Gross Income is $75,000, it would take an uninsured loss of more than $7,600 (10% of your AGI plus $100) before you could even start counting your losses against your income. 

All of which is not to say that people don’t sometimes suffer catastrophic losses like what we’ve seen in Mississippi and Alabama this week.  What happens then?  Let’s use this scenario:

Your home and its contents are insured for $150,000.  A tornado basically destroys everything, and the claims adjuster places the total loss at $300,000.  You receive a check for $150,000 from the insurance company and are able to salvage $5,000 worth of property from the wreckage, so you have a total casualty loss of $145,000. 

Your Adjusted Gross Income for the year was $80,000 and so that reduces your deductible loss by $8,000.  Combine that with the $100 IRS-designated reduction, the amount you can claim on your Schedule A for a Casualty, Disaster & Theft loss is $136,900.  

Now with only $80,000 in Adjusted Gross Income and $136,900 in deductible losses (that’s not including the usual itemized deductions for income taxes paid and so forth), clearly you’re not going to owe any taxes this year because your deductions are greater than your income.  What’s more, the IRS will allow you to carry back these losses up to five years.

What does that mean?  Let’s say that your modified Adjusted Gross Income – this is your AGI minus other itemized deductions and exemptions – comes to $60,000 for the year and you have a $136,900 casualty deduction.  Subtract the $60,000 from the $136,900 and you have zero taxable income for the year, along with $76,900 left over.  This is what’s called a Net Operating Loss or NOL.

You can then carry that Net Operating Loss back to the previous year and amend your tax return to claim this as a loss for the previous year.  All things being equal, you’re probably not going to owe any taxes for the previous year and will get back whatever you had originally paid.  If there’s still a remaining Net Operating Loss, you can carry it back to the next preceding year until you’ve used up the entire amount.  

In the scenario I’ve described, you would realize a savings on your taxes of a less than $20,000 when all is said and done – the actual amount will depend on a host of other factors that would effect your final tax liability.  That’s a good thing, of course, and after a disaster you need whatever help you can get.  But it hardly makes up for the loss of your house and all your belongings.

So as I said earlier, I’m glad that the Casualty, Disaster & Theft tax deduction is out here, but I pray that you’ll never need it.

Thanks for reading.