Virtually everyone has suffered a loss at one time or another as a result of some accident, which can be covered by damage insuranceor outright theft.
Tornadoes, earthquakes, fires, hurricanes and other natural disasters cost taxpayers and insurance companies billions of dollars in losses every year.
Thefts, particularly car thefts and burglaries of personal residences, are in a separate category, also costing taxpayers and policyholders billions of dollars a year.
This article will describe what types of claims and thefts are deductible, who can deduct a loss and when the loss can be deducted.
The Sudden Event Test
To be tax deductible, an accidental loss must meet the criteria of the sudden event test, which requires the following:
- The loss must occur as a result of a sudden and unforeseeable or unusual event.
- The event must be one that occurs in a single instance, so to speak, such as a car accident, and cannot have occurred over a long period of time.
- There must be an element of chance or some kind of natural force involved.
Under this definition, losses due to the following events would qualify for a deduction:
- Natural disasters, such as earthquakes, hurricanes, typhoons, tornadoes, floods, fires and avalanches.
- Losses due to civil unrest, such as riots
However, there are several types of losses that would not qualify for a deduction:
- Those incurred due to long-term processes, such as erosion, drought, wood decay, or termite damage.
- Any loss resulting from Internal Revenue Agency (IRS) considers it a “foreseeable” event.
Key points to remember
- All claims and thefts are not deductible. It depends on the circumstances and the eligibility of the loss.
- For a claim to be tax deductible, it must meet specific criteria for the sudden event test.
- If you have trees and shrubs on your property, any loss relating to those greens must meet the sudden event test criteria.
- A theft loss can only be deductible if the taxpayer can prove with hard evidence that the loss was caused by the theft.
Example of non-deductible loss
A couple owns a house perched on a cliff, with the rest of the neighborhood overlooking the city. Unfortunately, erosion causes several houses adjacent to their property to collapse and fall over the cliff. However, their property was undamaged and city building officials allow them to continue living there.
When they try to sell their house three years later, they discover that the value of their house has dropped by $150,000 due to buyer hesitation resulting from the negative public perception of the property due to the disaster. They are forced to sell their house for $175,000 less than they paid for it. Neither this loss nor losses incurred by homeowners whose houses collapsed are deductible.
Who can deduct a loss and when?
Only the owner of property who is lost can deduct the loss, within certain limits, in the year the loss was incurred. Losses related to theft are deductible in the year the owner discovers that the property was stolen.
If you rent property that is lost or destroyed as a result of a sudden and unforeseeable event that gives rise to a deduction, you may be able to deduct payments you make to the lessor which compensate for the loss.
If, on the other hand, the taxpayer expects to be fully reimbursed for the loss in a subsequent year, then the loss (or at least the amount of loss for which the taxpayer reasonably expects remuneration) need not be deducted in the year the loss is incurred. If the refund is never paid, the loss must still be claimed in the year it was incurred by filing an amended return for that year.
For example, if a taxpayer’s home is destroyed by fire in 2019 and the taxpayer expects to receive insurance proceeds in 2020, the taxpayer should not report a loss on the 2019 return. However , if the insurance company denies the claim in 2020, the taxpayer must file an amended return for 2019 to report the loss.
Losses from insolvent banks and other savings institutions
When a financial institution offering submission of the application becomes insolvent, its customers may deduct all uninsured losses as claims or non-commercial bad debts. If none of the losses were insured, an investment loss may be claimed instead.
However, investment losses are limited to $20,000 per institution and are also subject to the 2% Adjusted Gross Income (AGI) threshold. The institution must be under federal and/or state jurisdiction for any loss to be deductible.
Losses of trees and shrubs
Any loss relating to trees and shrubs must meet the sudden event test, although in this case it could include insect destruction if there is a sudden invasion lasting only a few days.
Greenery losses on personal property are calculated by comparing the total value of the property before and after the damage. Structures, land and growth are grouped together for this purpose. However, trees and shrubs are valued independently for business property.
For a loss due to theft to be deductible, the taxpayer must prove that the loss was due to theft – a mere suspicion of theft is not enough. If the property is simply missing, a theft loss cannot be claimed.
For example, if you walk out of your house one morning and find that the empty children’s pool that was in your yard the night before is gone, you cannot claim a deduction for its loss because there is a chance that it exploded. But if you go out to collect your mail and find that your mailbox has been uprooted from its post, that would be considered a loss due to theft as there is no other reason why your mailbox would be missing, very most likely.
Acceptable evidence of theft may include statements from witnesses who saw your property stolen, police reports, and newspaper accounts of the burglary.
Calculation and declaration of losses in the event of damage and theft
Accident and theft losses are miscellaneous itemized deductions that are reported on IRS Form 4684, which is carried forward to Schedule A, and then to Form 1040. Therefore, for a loss or theft to be deductible, the taxpayer must be able to itemize the deductions. If this is not possible, no loss can be claimed.
There are also other conditions that must be met. Generally, the amount must be greater than $500 and meet the 10% Adjusted Gross Income Limit.
For example, Carl has a loss of $2,500 to cover his car insurance deductible when his car is totaled. Her home is also broken into later that year and $3,000 worth of jewelry is stolen. His adjustable gross income was $40,000 last year and he is able to itemize deductions.
His losses can be calculated as follows:
|$2,500 – $500||$2,000|
|$3,000 – $500||$2,500|
|IGA limit of 10%||$4,000|
|Actual deductible amount||$500|
A separate floor of $500 is subtracted from each loss, then the remaining amounts are totaled. The IRS has arbitrarily mandated that any amount over the 10% AGI limit is then deductible. Any amount reimbursed by insurance is not deductible and any amount reimbursed by insurance in a subsequent year must be reported as income.
Only personal property losses can be reported on Form 4684. Business losses are deducted elsewhere. Claims and theft can be carried back three years or forward up to 20 years. Any excess loss can be carried back and forth as net operating loss.
Taxpayers who suffer losses from a disaster in a disaster area declared by the President have the option of reporting their loss on their previous year’s tax return, allowing them to amend the return and receive a immediate reimbursement as a relief measure.
The Federal Emergency Management Agency maintains an up-to-date list of all eligible disaster areas and the years for which they are eligible. Those who do will be required to provide a statement describing their election to take the deduction in the previous year and provide basic information about the time, location and nature of the disaster.
The deadline for this election falls on either the standard filing deadline for the current tax year or the deadline with extensions for the previous tax year. Those who elect to claim a previous year’s loss and then change their mind have 90 days to rescind the election and return any refund that was paid.
Victims in these areas do not have to meet the AGI 10% threshold rule if they suffered a net catastrophe loss (meaning the loss exceeded any amount of insurance or other compensation ). They also don’t have to itemize deductions; in this case, they would report the loss on Form 4684 of the standard deduction worksheet. Those who will detail will report it in the usual way on Schedule a.
The IRS allows limited deductions for damage and theft as a measure of relief for those who are victims of theft or natural disaster. There are many rules and regulations relating to claims and theft that are beyond the scope of this article. For more information on this, go to IRS website or see IRS Publication 547.
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