Tax Considerations for Derecho Damage

September 3, 2020 | Kristine A. Tidgren

Many are reeling from the damage caused by the derecho which tore through the Midwest on August 10, 2020. Farmers lost grain bins, outbuildings, crops, and much more. Clean up is ongoing with hundreds of trees uprooted and strewn across lawns. This post provides an overview of some of the tax issues associated with the destruction, clean-up, and rebuilding.

A casualty is damage, destruction, or loss of property caused by an identifiable event that is “sudden, unexpected, or unusual.” See, e.g., Matheson v. Commissioner, 54 F.2d 537 (2d Cir. 1931). The derecho is a quintessential casualty. Determining the tax treatment of a casualty depends upon a number of factors, including:

  • Whether the property was used in a trade or business or held for the production of income (as opposed to being used for personal use),
  • How much the property had been depreciated,
  • Whether insurance proceeds were received, and
  • Whether damaged property was restored or replaced

Depending upon the facts and circumstances, taxpayers experiencing damage from the derecho may have a casualty loss, a casualty gain, or a tax-deferred involuntary conversion.

The Starting Point is Basis

In the case of business property or property held for the production of income, the starting point in determining the tax consequences of a casualty is the adjusted basis of the damaged or destroyed property. Under IRC § 1012, the adjusted basis is generally the cost of the property minus accumulated depreciation or any IRC § 179 expense that has been taken, plus the value of any improvements. IRC § 1016 requires taxpayers to adjust the basis of property for expenses, receipts, losses, or other items properly chargeable to capital account.

Business Casualty Loss

A casualty loss deduction is generally allowed for a casualty loss sustained during the taxable year that is not compensated by insurance or otherwise. Under IRC § 165(c), taxpayers may deduct casualty losses incurred in a trade or business or a transaction entered into for profit. The calculation of the casualty loss depends upon whether the property is damaged or totally destroyed.

Note: From 2018 through 2025, losses on personal use property are only deductible if they arise from a casualty attributable to a federally declared disaster.

Less than Total Destruction

If the property is damaged, but not totally destroyed, the amount of a casualty loss is equal to:

  • The lesser of (1) the property's adjusted basis or (2) its decline in value, which is the fair market of value of the property after the disaster subtracted from its fair market value before the disaster  

Minus

  • Expected insurance or reimbursement received

See Treas. Reg. § 1.165-7(b)(1).

Example:

John’s barn was severely damaged by the windstorm . John’s adjusted basis in the building, for which he had taken straight-line depreciation, was $100,000. The value of the building before the storm was $200,000. The value of the building after was $150,000.  John received $40,000 in insurance proceeds. In this example, John’s casualty loss is calculated as follows:

$50,000 (lesser of AB or decline in value) - $40,000 (insurance payment) = $10,000 casualty loss

The basis, insurance payment, fair market value before casualty and fair market value after casualty are reported on Form 4684, Section B. The loss is reported on Form 4797 as an ordinary loss.

Basis is then decreased by any insurance proceeds received and any casualty loss recognized. It is increased by the amount spent on restoration. The new basis in John’s building after the recognized loss is $50,000 (100,000 - 40,000 - 10,000) (IRC § 1016(a)(1)). If John uses the insurance proceeds to restore the roof, the basis is increased to $90,000.

Determining the Fair Market Value

The law allows the taxpayer to establish the FMV of the property before the casualty by either: (1) obtaining an appraisal from a competent appraiser (Treas. Reg. 1.165-7(a)(2)(i)) or (2) by using the cost of repairs method. Treas. Reg. 1.165-7(a)(2)(ii).  The IRS will review each return based on the particular facts and circumstances. Taxpayers can face substantial underpayment of tax penalties for overvaluations. When determining the decrease in FMV of the property after a disaster, the cost of cleaning up or repairing property (the cost or repairs method) may be used only if the following conditions are met:

  • The repairs are actually made.
  • The repairs are necessary to bring the property back to its condition before the casualty.
  • The amount spent for repairs isn't excessive.
  • The repairs fix the damage only.
  • The value of the property after the repairs is not, due to the repairs, more than the value of the property before the casualty.

Total Destruction

If the property is totally destroyed, the casualty loss is equal to:

  • The property’s adjusted basis

Minus

  • Any salvage value minus insurance proceeds or reimbursement expected to be received. See Treas. Reg. § 1.165-7(b)(1)(ii).

Example:

If John’s grain bin, with an adjusted basis of $15,000 was totally destroyed in the wind storm and he received $10,000 in insurance proceeds, his casualty loss is $5,000.

The basis, insurance payment, fair market value before casualty and fair market value after casualty are reported on Form 4684, Section B. The loss is reported on Form 4797 as an ordinary loss.

What about demolition costs?

Under IRC § 280B, demolition costs and the basis of any destroyed structures are generally capitalized and added to the basis of the land on which the demolished structures were located. If a casualty damages or destroys a structure, and the structure is then demolished, the basis of the structure must be reduced by the casualty loss allowable under IRC 165 before the “loss sustained on account of” the demolition is determined. See IRS Notice 90-21.

Example:

In the last example, John’s adjusted basis in the destroyed grain bin after subtracting the insurance proceeds and the casualty loss would be zero. Any demolition and removal costs would be added to the basis of the land. The cost of any new grain bin would become the new bin’s basis. See IRC § 1016(a)(1).

General Business Casualty Loss Rules

Business casualty losses are determined on a property-by-property basis. Taxpayers are not allowed to aggregate their properties together when making the calculation.

Under § 165(i)(1), a taxpayer may elect to take into account any loss occurring in a disaster area and attributable to a federally declared disaster for the taxable year immediately before the taxable year in which the disaster occurred. In such a case, the casualty is treated as having occurred in the year for which the deduction is claimed. This loss cannot exceed the uncompensated amount determined on the basis of the facts existing at the date the taxpayer claims the loss. This election is made on an amended return for the prior year.

If a taxpayer deducts a casualty loss but then receives a reimbursement in a later year, the taxpayer does not amend the earlier return, but instead includes the reimbursement in income for the year in which the reimbursement is received in accordance with the tax benefit rule.

Note: Losses for livestock and crops raised for sale are not deductible because they don’t have a tax basis. The costs of production are deducted along the way. Likewise, the total loss of a prospective crop being grown in the business of farming is not deductible as a casualty loss. Treas. Reg. § 1.165-6. Plants such as vineyards and fruit trees (pre-productive period of more than two years), however, may have a basis if the taxpayer applied the UNICAP rules and capitalized the expenses.

Passive loss rules do not apply to business casualty losses. IRC § 165(c)(3).

A Word About Insurance Proceeds

Casualty losses are determined based upon actual and expected proceeds. Any casualty loss must be reduced by these proceeds, even if the payment won’t be made until the following year.  In the year of reimbursement, the amount may need to be adjusted on that year’s tax return. If the reimbursement is less, a loss is realized in the year of reimbursement. If the reimbursement is more, the reimbursement is included in income, but only to the extent the original casualty loss deduction reduced tax for the prior year.

Casualty Gain

If the total insurance compensation that a taxpayer receives is more than the adjusted basis in the destroyed or damaged property, the taxpayer will have a casualty gain, not a loss. This is very common with farm assets that are frequently fully expensed or depreciated.

Example:

Suppose John from the earlier examples took an IRC § 179 deduction when he purchased his grain bin and his basis in the grain bin was zero. In this example, the $10,000 of insurance proceeds for the destroyed grain bin would be a casualty gain.

The basis, insurance payment, and gain on the grain bin would be reported on Form 4684. Because the bin is § 1245 property, its deemed sale must be reported on Part III of Form 4797. This is reported as ordinary income, not subject to self-employment tax if John chooses to recognize the gain. But see involuntary conversion section below for a deferral option.

Involuntary Conversion Deferral (Section 1033)

Whether a casualty gain is presently taxable depends upon whether the insurance proceeds are reinvested in replacement property. Under IRC § 1033(a)(2)(A), a taxpayer may elect to defer the gain if the replacement cost is equal to or greater than the insurance recovery. The basis from the destroyed property is carried over to the basis for the replacement property and the gain is recognized upon any future sale of the replacement property. To qualify for deferral, the taxpayer must purchase replacement property that is “similar or related in service or use to the property destroyed” or the taxpayer must purchase a controlling interest (at least 80%) in a corporation owning such property.

The property must generally be replaced within two years after the close of the first taxable year in which any part of the gain is realized, although the Secretary of the Treasury may extend that period.  IRC § 1033(a)(2)(b). Taxpayers have four years to replace property damaged in a federally-declared disaster area.

Example:

In the last example, John may elect to defer recognition of the $10,000 gain if he pays at least $10,000 to construct another grain bin. If he defers, the $10,000 casualty gain would reduce the basis of the new grain bin.  

Note: Taxpayers should consider whether deferral is the best option. In some cases, it may be advantageous to recognize the gain in the year of the disaster.

Related Party Limits

If the replacement property or stock is acquired from a related person, gain generally can't be postponed by:

  • A C corporation
  • Partnerships in which more than 50% of the capital or profits interest is owned by a C corporation, OR
  • Any other taxpayers, unless the aggregate realized gains on the involuntarily converted property are $100,000 or less for the tax year. This rule applies to partnerships and S corporations at both the entity and partner or shareholder level.

Special Rule for Federal Disaster Areas

A special rule exists for casualty gains arising in a federal disaster area. Under IRC § 1033(h)(2), any tangible replacement property held for use in a trade or business is treated as similar or related in service or use to any property held for use in a trade or business or for investment if:

  • The property being replaced was damaged or destroyed in a disaster, and
  • The area in which the property was damaged or destroyed was declared by the President of the United States to warrant federal assistance because of that disaster.

Note: IRC § 165 (i)(5) defines “Federally declared disaster” to mean any disaster subsequently determined by the President of the United States to warrant assistance by the Federal Government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act.

Example:

If John in the above example was located in a federally declared disaster area, he could defer recognition of the casualty gain by purchasing any tangible trade or business property. He could decide not to rebuild the grain bin and elect, for example, to defer the gain and subtract it from the basis of a new tractor purchased for his farming business.

General Election Rules

A taxpayer must report the details of an involuntary conversion resulting in gain for each tax year in which the gain is realized. Treas. Reg. § 1.1033(a)-2(c)(2). Taxpayers must use Form 4684 to report involuntary conversions due to a casualty.

A taxpayer chooses to defer casualty gain by not reporting gain in the first year it is realized. A statement including the details of the conversion is attached to the return. This statement must be made by the corporation or a partnership if the loss was attributed to an entity. Details in the statement include:

  • The date and details of the casualty
  • The insurance or other reimbursement received from the casualty
  • How the gain was determined
  • Any replacement property acquired before return was filed, including:
    • The replacement property
    • The postponed gain
    • The basis adjustment that reflects the postponed gain
    • Any gain being reported as income
  • If the taxpayer intends to acquire replacement property after filing the return for the year of the gain, the statement should also state:
    • that the taxpayer is choosing to replace the property within the required replacement  period.
    • Another statement must be attached to the return for the year in which the taxpayer acquires the replacement property.  This statement must contain detailed information about the replacement property.

Repairing Casualty-Damaged Property

Sometimes, a taxpayer may be able to take advantage of the tangible property regulations to presently deduct the cost of repairing casualty damage. As explained above, casualty losses cannot be greater than the taxpayer’s adjusted basis, and the basis must be reduced by any loss taken. If the reduction in basis is less than or equal to the taxpayer’s adjusted basis in the building, amounts paid to restore the damage to the building must be treated as an improvement and must be capitalized. If the amounts paid to restore the property exceed the adjusted basis of the property prior to the loss, the amount required to be capitalized is limited. Treas. Reg. § 1.263(a)-3(k)(4)(i). In that case, costs required to be capitalized are limited to the excess (if any) of the taxpayer’s basis adjustments resulting from the casualty minus the amount paid for restoration that constitutes a restoration under one of the other five criteria of Treas. Reg. § 1.263(a)-3(k)(1). 

Example:

The derecho damaged Jerri’s farm building that had a $75,000 adjusted basis. Jerri did not receive any insurance proceeds, but deducted a $75,000 casualty loss. She then paid $90,000 to repair the damage and restore the building to its usual condition.  Jerri must capitalize $75,000 of the $90,000 cost, but she may deduct the $15,000 as repair costs under Treas. Reg. § 1.263(a)-3(k)(1) if the costs were expended to repair, not improve, the building. 

Destruction of Personal Use Property (Such as a Home)

Although the focus of this post was on business property, it should be noted that casualty losses and gains must be considered for damage to personal use property as well. The rules for this type of property, however, are very different.

The Tax Cuts and Jobs Act changed the law so that from 2018 to 2025, personal casualty losses are deductible only if they are attributable to a federally declared disaster. Outside of a disaster area, a personal casualty loss remains deductible if the taxpayer has personal casualty gain, to the extent that the loss doesn't exceed the gains. See IRC § 165(h)(5).

For taxpayers experiencing loss of personal use property in a federally declared disaster area, two limitations apply to a casualty loss deduction: (1) the loss must exceed $100, and (2) aggregate losses may be deducted only to the extent they exceed 10% of adjusted gross income. If a taxpayer has property used partly for personal use and partly for business use, he or she must allocate the loss amount.

Note: Under IRC § 139, a taxpayer may exclude from income qualified disaster relief payments received as the result of a qualified disaster. It should also be noted that casualty gain arising after the destruction of a home is usually excludable from income under IRC § 121.