Tax relief may be available for damage from federally declared disasters

In brief

Major storms and other natural disasters can cause significant property damage each year. Taxpayers affected by these disasters may be eligible for certain tax relief.

For example, federal tax provisions allow a casualty loss deduction for partial destruction of property, favorably modify the rules for involuntary conversions resulting from certain disasters, allow certain disaster losses to be claimed in the preceding tax year, and provide an enhanced deduction for charitable contributions of inventory used to assist disaster victims. The IRS regularly provides relief to taxpayers in federally declared disaster areas by, for example, extending filing and payment deadlines and abating certain penalties.

For consideration:  Taxpayers affected by hurricanes, floods, tornadoes, wildfires, or other federally declared disasters should check whether their area is declared a federal disaster area and be aware of the tax relief that may be available to help alleviate the economic burden of the disaster. Careful planning is necessary to report losses, recoveries, reinvestments, and charitable contributions of inventory accurately and to take advantage of available tax benefits.

Disaster loss deduction

Section 165 allows a deduction for a loss sustained during the tax year that is not compensated for by insurance or otherwise. In general, a taxpayer may recognize a loss only if the property is completely worthless. For a casualty loss resulting from an identifiable event of a sudden, unexpected, or unusual nature, however, a taxpayer may deduct a loss for partial destruction or the reduction in value of the damaged property. The loss generally is measured by comparing the value immediately before the casualty with the value immediately after the casualty, but is limited to adjusted basis.

Generally, personal casualty losses of individuals are subject to certain limitations. The 2017 tax reform act (Act) disallows personal casualty loss deductions for individuals for losses incurred in tax years beginning after 2017 and before 2026, except (1) to the extent the taxpayer has personal casualty gains or (2) if the loss is attributable to a federally declared disaster.

An individual or business taxpayer in a federally declared disaster area also may elect to deduct a loss attributable to the disaster in the tax year immediately preceding the tax year the loss is sustained (the ‘preceding year’ and the ‘disaster year’). For example, a calendar-year taxpayer in states that have been declared federal disaster areas as a result of Hurricane Ida may claim a disaster loss sustained from that storm on the taxpayer’s 2020 federal income tax return (return), although the loss occurred in 2021. A loss for which a taxpayer makes the election is treated for all federal tax purposes as occurring in the preceding year (the tax year the taxpayer claims the deduction).

Regulations under Section 165 provide rules for the time and manner for making this election. A taxpayer must make the election on an original or amended return for the preceding year in the manner specified by other guidance. For example, Rev. Proc. 2016-53 provides that a taxpayer makes or revokes the election by attaching a statement to an original or amended return providing certain specified information. Taxpayers may submit the required statement by completing Section D of IRS Form 4684, Casualties and Thefts.

A taxpayer must make the election no later than six months after the unextended due date for filing the taxpayer’s return for the disaster year. A taxpayer may revoke an election within 90 days after the due date for making the election. A taxpayer revokes the election by filing an amended return for the preceding year on or before the date the taxpayer files its return (or amended return) for the disaster year and claims the loss. A taxpayer that claims the loss on its return for the disaster year and wishes to make the election to claim the loss in the preceding year must file an amended return for the disaster year on or before the date the taxpayer files an amended return making the election for the preceding year.

Example 1.  In 2020, individual taxpayer J sustains a disaster loss in a federally declared disaster area. J makes the election to claim the loss in 2019 by filing an amended return for the 2019 tax year on August 15, 2021, which is within the six months following J’s unextended filing due date for filing her 2020 return.  J files her 2020 return on September 15, 2021.

Example 2.  J decides to revoke her election to claim the loss in 2019 and to claim the loss on her 2020 return instead. J may file an amended return for 2019 revoking the election and an amended return for 2020 claiming the loss. J must file the 2019 amended return revoking the election by January 13, 2022 (within 90 days after October 15, 2021) and on or before the date J files a 2020 amended return claiming the loss.

Example 3.  In 2020, individual taxpayer K sustains a disaster loss in a federally declared disaster area. K claims the loss on his 2020 return filed on April 15, 2021. K then decides to elect to claim the loss on his 2019 return. K may make the election on or before October 15, 2021, by filing a 2019 amended return claiming the loss deduction. K must file a 2020 amended return omitting the loss deduction on or before the date of filing the 2019 amended return.

Insurance and similar recoveries

Insurance proceeds and other payments a business receives as a result of a casualty generally are characterized as either payments for lost profits or payments for lost property. Compensation for lost profits is currently taxable. Compensation for loss of the use of property or for property damage generally is treated as a recovery of capital and is taxable only to the extent the amounts received exceed the property’s basis (without regard to possible involuntary conversion treatment discussed below).

Under certain insurance policies (e.g., business interruption), whether payments are intended to compensate for lost profits or for lost property (or a combination of both) may be unclear. The courts have considered factors such as (1) the existence of additional policies with specific coverage, (2) the nature of the casualty triggering the insurance recovery (i.e., suspension of business or the loss of property), (3) how the amount of the insurance recovery is computed, and (4) whether the payment is approximately equivalent to the replacement cost of property.

Enhanced deduction for charitable contributions of inventory

Many businesses assist disaster victims by donating inventory such as food, clothing, toiletries, and medical supplies to charities. Section 170(e)(3) provides a special enhanced deduction for inventory a C corporation contributes to a qualified tax-exempt charity that uses the inventory solely to care for the ill, infants, or needy (e.g., disaster victims) in a manner related to the purpose constituting the basis for the charity’s tax exemption. The charity may not transfer the inventory in exchange for money, other property, or services; the taxpayer must obtain a written statement from the charity that includes certain required representations; and any inventory subject to regulation under the federal Food, Drug, and Cosmetic Act must have fully satisfied the applicable requirements of that act and related regulations for 180 days before the date of transfer.

In general, the amount of a charitable contribution of property is the fair market value (FMV) of the property, subject to certain reductions. For ordinary income property (e.g., inventory), the reduction generally is the difference between the FMV and the basis of the property. Therefore, the charitable contribution deduction is equal to the basis of the inventory. However, the amount of the enhanced deduction for qualified contributions of inventory equals the lower of (1) FMV of the inventory less 50% of the difference between the FMV and the basis of the inventory or (2) twice the basis of the inventory. Thus, C corporations making qualified donations of inventory to charities that will use the inventory to care for disaster victims may take a charitable contribution deduction equal to the basis of the inventory plus 50% of the gain, limited to twice the basis of the inventory.

Note:  In general, the total charitable contribution deduction for a C corporation is limited to 10% of the corporation’s taxable income (as defined under Section 170 for purposes of charitable contributions).

Trades or businesses that are not C corporations (e.g., S corporations, partnerships, and sole proprietors) may claim the enhanced deduction only for charitable contributions of food inventory. Thus, farmers, retail grocers, and restaurants that do not do business as C corporations have an opportunity to claim the enhanced deduction for qualified charitable contributions of food inventory.

The total deduction for charitable contributions of food inventory generally is limited to 15% of taxable income for C corporations and, for taxpayers that are not C corporations, to 15% of the taxpayer’s aggregate net income for the tax year from all trades or businesses from which the contributions are made. However, the annual deduction limitation for contributions of food inventory by a business in 2020 and 2021 is increased from 15% to 25% of taxable income or aggregate net income.