My home was destroyed- what deduction can I take? How do casualty losses work?
IRS Publication 584 specifically deals with casualty, disaster and theft losses. Typically, you may deduct losses to your home, household goods, and motor vehicles on your tax return but there are certain rules.
First, you must compute the amount of loss-
Determine your cost basis in the property before the casualty or theft. This will usually be your purchase price plus any costs to acquire the property including any improvements.
Next, determine the reduction in fair market value (FMV) of the property as a result of the casualty or theft. This can be challenging since it might require a current appraisal or estimates from contractors showing the cost to bring your property back to the value it was before the loss.
The contractor estimate angle can further be complicated since most people want to make their property better than it was. In other words, if you need to install new countertops, why not spring for granite even though the original countertops were Formica. So you’ll need to be very careful when determining the decrease in fair market value if you plan on upgrading your property when performing repairs.
From there, take the smaller amount of your cost basis or the reduction in fair market value. This is the maximum loss you may deduct. For example, you had $100,000 as a purchase price, plus $100,000 in improvements for a total of $200,000 in cost basis. Your fair market value before the loss was $500,000, and now the FMV is $200,000, a difference of $300,000. You can only deduct $200,000 (as opposed to $300,000).
There is some silver-lining in our example. Remember, most increased values of homes are due to location (land is rarely destroyed). So hopefully the reduction in fair market value is only limited to your building costs, and those costs are typically aligned with your cost basis.
Back to the smaller amount selection- from there you must deduct any insurance reimbursements or proceeds received related to your loss.
Be aware- you may not deduct a casualty or theft loss that is covered by insurance unless you filed a timely insurance claim for reimbursement. Any reimbursement you receive will reduce the loss. If you did not file an insurance claim, you may deduct only the part of the loss that was not covered by insurance.
Second, after your loss is determined you must reduce each casualty or theft loss by $100 ($100 rule). Then, you must further reduce the total of all your losses by 10% of your adjusted gross income (10% rule).
99% of the time, if you are adequately insured and reimbusred, you will never overcome the $100 and 10% rules, and so your deduction will be zero. Having said that, floods and other non-insurable hazards might change this.
After all that, if you still have a deductible loss, the loss is deducted on Schedule A and it only reduces your taxable income. Here are some numbers. You have a $25,100 loss and your income is $50,000. Your loss is now $20,000 ($25,000 minus $100 minus 10% of your income). Let’s say your effective tax rate is 10%. Your $20,000 loss saved you $2,000- you still are out of pocket $18,000. While any deduction helps, we feel it is important that taxpayers understand what the bottom line is to deducting casualty losses.