Analysis brought to you by the tax experts behind Tax Facts, a reference solution that helps to answer critical tax questions and provides the latest tax developments. Learn more about Tax Facts here!
The spread of COVID-19 in the United States has business owners, advisors and brokers wondering how to prepare. From a tax and insurance perspective, issues related to casualty losses, disaster areas, and involuntary conversions is a critical area to consider.
When businesses face new threats like COVID-19, there are always questions about the tax treatments of business losses and expenditures related to the prevention of, and recovery from, an interruption in business operations.
The rules governing casualty losses may not apply because the losses are to business operations rather than business property. There are additional rules governing losses in a federal disaster area.
Finally, in the worst-case scenario, business property may be subject to involuntary seizure if the closure of that property may aid in the prevention of the spread of disease. This, too, has potential tax implications.
What is a casualty loss?
A casualty loss is a loss that an individual taxpayer suffers as a direct result of an event that meets the following criteria:
- It is identifiable;
- It is damaging to property; and
- It is sudden, unexpected and unusual in nature.
Generally, casualty losses are deductible during the taxable year that the loss occurred.
Under the 2017 Tax Act, individuals are no longer entitled to deduct casualty and theft loss expenses as itemized deductions (when those losses are not related to property used in a trade or business). An exception exists for losses that occur in federally declared disaster areas.
However, if a taxpayer has personal casualty gains, the new rules do not apply (even if the loss does not occur in a federal disaster area) so long as the losses do not exceed the gains. This essentially means that casualty losses will continue to offset casualty gains.
Special rules governing for federal disaster areas
In recognition of the fact that taxpayers who sustain casualty losses as a result of disasters often have an immediate need for relief, the IRC contains provisions that accelerate the recognition of tax benefits to which disaster victims are entitled.
The 2019 Tax Certainty and Disaster Relief Act extended the rules governing qualified disaster distributions from retirement accounts, discussed below for victims of disasters that occurred in 2018 through 60 days after the enactment of the bill (December 20, 2019). Qualified disaster areas generally include any area the President declares as such.
What about losses related to taking preventative measures?
Costs incurred by a taxpayer in order to prevent a potential casualty loss are not deductible under IRC Section 165 as casualty losses. According to the courts, such preventative steps are not sudden and unexpected in nature, and thus do not qualify as events giving rise to casualty loss treatment.
What if the taxpayer is compensated by insurance?
In general, a casualty loss deduction is only allowable to the extent that the taxpayer is not otherwise compensated for the loss by insurance or reimbursement from another third party.
What are the tax consequences of an involuntary conversion?
IRC Section 1033 applies in cases where property is compulsorily or involuntarily converted. This provision recognizes that a taxpayer who has suffered an involuntary conversion has experienced economic hardship and may not have the ability to pay taxes on any gain resulting from the conversion. This is because any proceeds in excess of the taxpayer’s basis in the converted property would generate taxable gain. Thus, IRC Section 1033 postpones recognition of the gain to the extent the proceeds obtained in the conversion, whether through insurance or otherwise, are reinvested in replacement property.
An “involuntary conversion” may be the result of the destruction of property (whether in whole or in part), the theft of property, the seizure of property, the requisition or condemnation of property, or the threat or imminence of requisition or condemnation.
Must a taxpayer’s property be completely destroyed to qualify for nonrecognition treatment under the rules governing involuntary conversions?
The involuntary conversion of a taxpayer’s property need not occur as a result of one sudden event (e.g., a natural disaster) in order for the taxpayer to qualify for nonrecognition treatment under IRC Section 1033.
Despite this, if the taxpayer disposes of partially destroyed property that could have been repaired, nonrecognition treatment under IRC Section 1033 could be denied. This is because the decision not to repair is treated as “voluntary,” as contrasted with a conversion that is purely involuntary.
How do the rules governing theft and casualty losses interact with the rules governing involuntary conversions of property?
The rules governing theft losses frequently intersect with the IRC Section 1033 provisions governing involuntary conversions. The rules on involuntary conversions govern the treatment of any reimbursement that a taxpayer receives as a result of a loss, such as a casualty or theft loss.
Therefore, if a taxpayer receives insurance proceeds, for example, that exceed the amount lost as a result of a casualty or theft, the taxpayer would look to the rules on involuntary conversions for determining whether the gain must be recognized. In these circumstances, the gain is characterized as stemming from an involuntary conversion because the casualty in effect causes the damaged property to suddenly be converted into cash from the insurance proceeds. The rules for determining what gain is or is not subject to taxation in involuntary conversions may differ for federally declared disasters.