Lessons on Casualty Losses From the O.J. Case and Others
Beverly Goodman
03/19/03 - 10:39 AM EST
Most of you probably don't think tax law qualifies as a good read.
And the Tax Court does indeed rule on some mind-numbing minutiae. But it also serves as a highly entertaining record of what taxpayers try to get away with -- and often do get away with.
The tax code allows you to claim casualty and theft losses that
are not covered by insurance as an itemized deduction. And it's in the gray area of what constitutes a casualty loss that makes for some good Tax Court reading. The Internal Revenue Service has disallowed many a casualty loss under its strict definition, while the Tax Court has often proved more generous. (These cases come courtesy of the ubiquitous
J.K. Lasser's Your Income Tax 2003.)
To be deductible as a casualty loss, property must be damaged or destroyed as the result of a sudden, unexpected or unusual event. That may sound obvious, but the IRS takes those terms quite literally. To be "sudden," the event must be swift, not gradual or progressive. A swarm of southern pine beetles that destroys your trees in five to 10 days counts as sudden, the court says. But a swarm of termites that eats a hole in your garage door is not, because termite damage requires years of infestation.
Ring Rules
Unexpected or unusual events must truly be unforeseen -- a result of pure chance or natural disaster that can't be anticipated under ordinary circumstances. While tornadoes, earthquakes and even vandalism from riots or other civil disorders clearly meet these criteria, it's the more mundane losses of everyday life that cause some dispute.
Mr. White accidentally slammed the car door on his wife's hand. In pain, she shook her hand vigorously. A diamond flew out of her ring's setting, which was loosened by the impact. The diamond was never found. The IRS disallowed the deduction, contending that a casualty loss requires a cataclysmic event. The Tax Court disagreed. A deductible casualty loss occurs whenever an accidental force is exerted against property, and its owner is powerless to prevent the damage because of the suddenness. The IRS has accepted the decision. -- J.K. Lasser's Your Income Tax
Apparently the Tax Court has seen its fair share of taxpayers destroying wedding rings. Mrs. Kane dropped her ring in a glass of ammonia in order to clean it. Alas, it wasn't long before
Mr. Kane emptied the glass into the sink and started the automatic garbage disposal. The ring was crushed. According to J.K. Lasser's, the court allowed a full deduction for the loss, saying it didn't matter if Mr. Kane was negligent; the loss of the ring resulted from a destructive force.
But the courts don't exist to play "good cop" to the IRS' "bad cop," and they frequently hold up IRS decisions. Neighbors of O.J. Simpson claimed that the double murder and ensuing media frenzy permanently decreased their property value, lowering the value of their home by at least $400,000. The Ninth Circuit appellate court ruled that a casualty loss requires actual physical damage caused by a fire, storm or other sudden unusual event, and not merely buyer resistance. The Tax Court issued a similar decision to O.J.'s next-door neighbors, who also claimed their homes were permanently devalued.
When to Deduct
Generally, casualty losses are deducted in the year the casualty occurs -- even if you don't repair or replace the property in the same year. Casualty and theft losses are claimed on Form 4684 (use a separate form for each claim). Figuring a casualty loss takes a few steps. First, calculate the loss itself -- generally the difference between the fair market value of the property before the casualty and the fair market value of the property after the casualty. You'll need appraisals to back up your claim; sentimental value doesn't count.
If your basis in the property -- what you paid to acquire and/or improve it -- is less than the loss amount, then that's the figure that becomes the figure used to determine your deductible casualty loss.
You're only allowed to deduct losses that are not covered by insurance, so subtract any insurance payments from your loss amount. Now, subtract $100 from the remainder. (I know, this is starting to sound like a joke.) You're only able to deduct the balance to the extent it exceeds 10% of your adjusted gross income. And unlike medical expenses, married couples can't file separately in order to "bunch" the deductions and reach the 10% threshold with greater ease -- only an owner can claim a casualty or theft loss. (For more on this strategy, see
Deductions for Your Health and Wealth.)
You can hold off on claiming a casualty deduction if you expect to be reimbursed but are not, or if you don't realize until the following year that damage was done. (And there are a slew of rules that apply only when your loss is from a disaster that the president has declared warrants federal assistance.)
If you didn't claim a casualty loss deduction because you expected insurance to cover the damage, but a year later discovered it would not, claim the deduction in the year the issue is settled with the insurer. In other words, whenever you find you have no reasonable prospect of recovery, that's when you claim the loss.
Theft
Theft losses and casualty losses are essentially figured the same way. The test for claiming a theft loss, though (again), seems more straightforward than it often is. Clearly, the loss of property must be due to an illegal act. Missing property should have supporting evidence that a crime was indeed committed -- witness reports, police records or even a newspaper account of the crime.
Money lost through fraud is also deductible as a theft loss. When a building contractor took off with a payment he received to build a residence, the would-be homeowner was allowed a theft loss deduction for the difference between the money in advanced to the contractor and the value of the partially completed house.
In a slightly more bizarre example of the same principle, a New York taxpayer who was suffering from depression and became attached to two fortune tellers was allowed to claim a $19,000 theft deduction. Under New York law, fortune-telling is considered a theft-related offense (unless it's at a show or fair for purely entertainment purposes). A gullible (or, I suppose, a depressed) person who thinks they will be helped by fortune-telling services has been duped or swindled; therefore a loss could be allowed in New York.
If your stolen property is recovered or the money is returned, you'll need to refigure your loss deduction and file an amended return. To recalculate the loss, go through the steps on Form 4684, but compute the loss in fair market value from the time the property was stole until you recovered it.
