Fed eases homeowner ‘casualty loss’ restrictions

“If you dare to file a claim on your homeowner’s insurance policy, we’ll cancel your policy no matter how long you’ve been our customer.” That seems to have become the motto of the homeowner’s insurance industry.

Just a few days ago, I received an e-mail from a homeowner who was insured with the same major national insurance company for more than 30 years. Last year she filed a $457 claim. The insurer paid because the loss was covered under the policy. But when her policy came up for annual renewal, the insurer refused to renew.

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As the result of situations like this, smart homeowners have quickly discovered it isn’t wise to file a homeowner’s insurance claim unless the loss is large. Also, homeowners are raising their homeowner’s insurance policy deductible as high as they can afford, realizing they can save on insurance premiums but they will have to pay the small losses themselves.

Because of the new attitude of homeowner’s insurers toward their policyholders, which seems to show that insurers want to get out of the homeowner’s insurance business, the income-tax casualty loss deduction has suddenly become more important than ever.

WHAT IS A CASUALTY LOSS? Uncle Sam says a tax-deductible casualty loss is an uninsured “sudden, unusual or unexpected” loss event. Fire, flood, earthquake, hurricane, tornado, mudslide, theft, accident, water damage, riot, embezzlement, vandalism, snow, rain, and ice storm damage, not paid by insurance, meet the test.

Internal Revenue Service policy has been to deny casualty loss tax deductions for casualty losses that were covered by a homeowner’s or business insurance policy. However, with the recent adverse consequences of filing insurance claims, the IRS seems to have lightened up and not denied casualty loss deductions that were insured for a policyholder who elected not to file a claim.

However, if the loss occurs too slowly to qualify as a “sudden, unusual or unexpected” casualty loss tax deduction, then the loss is not tax-deductible if the property owner elects not to file a homeowner’s insurance policy claim.

Examples of non-deductible, too-slow events include termite damage, carpet beetle infestation, dry-rot damage, dry well, rust, corrosion, growing plant loss, moth damage, Dutch Elm disease, erosion and mold.

When the President declares a disaster area, such as due to a major fire, flood, earthquake or hurricane, affected taxpayers can then deduct their uninsured casualty losses either in the tax year the loss occurred, or in the prior tax year by amending their previous year’s tax returns. The taxpayer then either receives a prior year tax refund, or a current year tax savings.

HOW MUCH OF YOUR CASUALTY LOSS IS TAX DEDUCTIBLE? If your personal loss meets the “sudden, unusual or unexpected” test, and if it was not paid by insurance, it qualifies as a casualty loss. However, it might not be fully, or even partially, tax deductible.

The reason is only personal casualty losses that exceed 10 percent of the taxpayer’s annual adjusted gross income, minus a $100 non-deductible “floor” per event, are deductible.

For example, suppose you had a kitchen fire at your home, which cost $10,000 to repair. But your homeowner’s fire insurance coverage paid only $7,500 because you were underinsured. That means you paid $2,500 of the loss out of your pocket. If your annual adjusted gross income is $50,000 or greater, the $2,500 uninsured portion of your fire loss is not deductible as a casualty loss. The reason is $2,500 is less than 10 percent of your adjusted gross income. However, if your adjusted gross income is $20,000 in this example, then $500 of your casualty loss would be tax deductible, minus the $100 “floor” for each casualty loss.

BE PREPARED FOR I.R.S. CASUALTY LOSS AUDITS. Because taxpayers often overstate their deductions on IRS Form 4694 used to calculate casualty losses, IRS agents love to audit casualty losses. If you repaired or replaced the casualty loss damage, the repair bill and payment check are excellent evidence to support your deduction.

However, repair estimates alone are not enough to support a casualty loss deduction. Police reports, photos of the lost or damaged property, and appraisals of before and after values are excellent proof of loss.

But the deductible loss is limited to the taxpayer’s adjusted basis for the damaged or destroyed property. Market value at the time of the casualty loss is irrelevant.

To illustrate, suppose you paid $100,000 for your uninsured second home, which was worth $300,000 when it burned to the ground in 2003. Your casualty loss is limited to the $100,000 adjusted cost basis, minus 10 percent of your 2003 adjusted gross income, minus the $100 “floor” for each personal casualty loss event. The actual cost of repairs exceeding the cost basis doesn’t matter.

But the casualty loss deduction can also include indirect casualty loss expenses, such as uninsured temporary housing costs, moving costs, and property protection expenses such as board-up and legal expenses.

If the casualty loss involved business property, however, then the full casualty loss is tax deductible as a business expense, regardless of the loss amount or the taxpayer’s income.

WILL FAILURE TO FILE AN INSURANCE CLAIM FORFEIT A CASUALTY LOSS TAX DEDUCTION? Until the last two years, homeowners rarely hesitated to file casualty loss claims under their homeowner’s insurance policies.

But in 2002 and 2003, homeowners quickly learned to only file insurance claims if their insured loss was large. Fear of policy non-renewal, and difficulty obtaining replacement homeowner insurance except at very high cost, drastically cut homeowner insurance claims.

So far, there have been no recent court rulings deciding whether an insured homeowner must first file an insurance claim before being entitled to claim a casualty loss tax deduction.

However, if an insurance payment exceeds the real property’s adjusted cost basis, that is a potentially taxable situation if the funds are not used to rebuild or replace. But when the insurance payment is for stolen or damaged personal property, the excess insurance money received exceeding the adjusted cost basis is not taxable, even if the items are not replaced.

But taxpayers in federal disaster areas, such as the recent southern California fire areas, have up to four years to reinvest their insurance payments in repairs or acquiring replacement property to avoid owing capital gains tax on their insurance payment gains.

CONCLUSION. The casualty loss tax deduction is frequently forgotten when you had an uninsured “sudden, unexpected or unusual” loss that exceeds the threshold of 10 percent of your adjusted gross income, minus a $100 per event “floor.” For full details, please consult your tax adviser.

Next week: Home business expense tax deductions.