Casualty and theft losses are claimed on Form 4684 and then entered on Schedule A, Form 1040. If you have a qualified hurricane disaster loss (18.12, 18.13), you can claim the loss as part of your standard deduction (13.1) even if you do not itemize other deductions on Schedule A.

A loss of property held for:

• Personal purposes is subject to the sudden events test (18.1) and a dollar floor that reduces the deduction by $100, or by $500 for a qualified hurricane loss (18.12). In addition, net losses for personal-use assets are reduced by 10% of your adjusted gross income on Form 4684, unless the loss is a qualified hurricane loss (18.12).
• Income-producing purposes, such as negotiable securities, should be claimed on Form 4684 and then entered on Line 28 of Schedule A as an “other miscellaneous deduction” not subject to the 2% of AGI floor (19.1).
• Business or rental purposes is claimed on Form 4684 and then as a loss on Form 4797. It is not subject to any floor. Follow the instructions to Form 4684.

Deductible casualty or theft losses are not subject to the income-based reduction of overall itemized deductions (13.7).

If you have realized a gain, you may defer tax by replacing or repairing the property (18.19).

Appraisal fees and other incidental costs, such as taking photos to establish the amount of the loss, are claimed as a miscellaneous itemized deduction subject to the 2% of AGI floor on Line 23 (“Other expenses”) of Schedule A, Form 1040.

Deductible casualty and theft losses are not subject to the reduction of itemized deductions that applies to certain higher income taxpayers (13.7).

18.1 Sudden Event Test for Casualty Losses

To be a deductible casualty loss, property must be damaged or destroyed as the result of a sudden, unexpected, or unusual event. A sudden event is one that is swift, not gradual or progressive. An unexpected event is one that is ordinarily unanticipated and unintended. An unusual event is one that is not a day-to-day occurrence and that is not typical of the activity in which you were engaged. Chance or a natural phenomenon must be present. Examples include earthquakes, hurricanes, tornadoes, floods, severe storms, landslides, and fires. Loss due to vandalism during riots or civil disorders also is treated as a casualty loss. Damage to your car from an accident is generally deductible (18.7). Courts have allowed deductions for other types of accidents; see Example 2 below. The requirement of suddenness is designed to bar deductions for damage caused by progressive deterioration, such as erosion, corrosion, and termite infestation occurring over a period of time.

The IRS and the courts have generally disallowed casualty deductions based on a loss in property value due to permanent buyer resistance rather than actual physical damage; see Examples 4 and 5 below.

Is drought damage deductible? The IRS does not generally allow deductions for drought damage. An IRS agent may argue that the loss resulted from progressive deterioration, which does not fit the legal definition of a personal casualty loss. Courts have allowed deductions for severe drought where the damages occur in the same year as the drought.

If the damage becomes noticeable a year later, a court will view this as evidence of progressive deterioration that does not qualify as a deductible casualty. Where there are drought conditions, inspect your property for damage before the end of the year and claim a deduction for the damage in that year to negate an IRS argument that damage was caused by progressive deterioration.

Damage to surrounding property. Loss due to buyer resistance because of damage to surrounding property is generally not deductible. However, the Eleventh Circuit allowed a deduction. See Example 4 above.

Damage to trees. The destruction of trees by southern pine beetles over a period of 5 to 10 days was held by the IRS to be a casualty. One court decided similarly where the destruction occurred over a 30-day period. For figuring the casualty deduction for tree and shrub damage (18.6).

Deduction despite faulty construction. A plumber stepped on a pipe that was improperly installed. Resulting underground flooding caused damage of over $20,000. The IRS argued that this was caused by a construction fault and thus was not a casualty loss. The Tax Court disagreed. The plumber caused the damage. Improper construction was only an element in the causative chain.

Deduction despite failure to get building permit. After a couple’s home was destroyed by fire, the IRS disallowed their casualty loss deduction because they had built the home without obtaining the requisite state and county building permits. The IRS claimed that allowing a deduction would frustrate state policy and in effect, make the federal government the insurer of last resort for owners of unpermitted, illegal homes. However, IRS Chief Counsel determined that the failure to obtain the permits was not enough to deny their deduction. There was no direct link between not getting the permits and the casualty loss, which resulted from an area-wide fire that they didn’t cause.

Foreseeable events and preventable accidents. The IRS may disallow a deduction by claiming that the loss was foreseeable and therefore not a deductible casualty loss; see the following Examples.

18.2 When To Deduct a Casualty Loss

Generally, you deduct a casualty loss in the year the casualty occurs, regardless of when you repair or replace the damaged or destroyed property. However, a deduction is allowed in the year you pay to repair corrosive drywall damage to your home or household appliances under a special IRS procedure (18.1). For a qualifying disaster area loss (18.3), you have the option of claiming the loss on your return for the year immediately preceding the year in which the disaster occurred.

If a casualty occurs in one year and you do not discover the damage until a later year, or you know damage has been inflicted, but you do not know the full extent of the loss because you expect reimbursement in a later year, here is what to do:

If you reasonably expect reimbursement in a later year. For the year the casualty occurred, you should deduct only that part of your loss, after applying the personal property floors (18.12) for which you do not expect reimbursement. For example, if your property was damaged in 2017 but you expect a full insurance recovery in 2018, you would not take any deduction on your 2017 return.

If you do not expect any reimbursement and deduct a loss on your 2017 return, but you receive insurance or other reimbursement in 2018, the reimbursement is taxable in 2018 to the extent that the 2017 deduction gave you a tax benefit by reducing your 2017 taxable income (11.6). You cannot avoid this income for 2018 by amending your 2017 tax return to reduce or eliminate the 2017 loss by the 2018 reimbursement.

You must file a timely insurance claim if your property is covered by insurance. Otherwise, the amount covered by the insurance cannot be taken into account when figuring your deductible casualty loss; see 18.13 and 18.16.

If your reimbursement is less or more than you expected. Assume a 2015 storm damaged your home and you did not claim a loss deduction on your 2015 return because you expected to recover your entire loss from your insurance company after 2015—but the insurance company refused to pay your claim. When do you deduct your loss? You deduct your loss in the year you find that you have no reasonable prospect of recovery. For example, you sue the insurance company in 2016, with a reasonable prospect of winning your claim. However, in 2017, a court rules against you. You deduct your loss on your 2017 return, subject to the personal property floors (18.12) . If you, as lessee, are liable to the lessor for damage to property, you may deduct the loss in the year you pay the lessor.

If you claim a loss and in a later year receive a larger reimbursement than you expected when you figured your deduction, you have to include the reimbursement in income for the year you receive it to the extent the deduction gave you a tax benefit (11.6). For example, if you claimed a loss on your 2016 return and in 2017 you receive a larger insurance reimbursement than expected, you must include the recovery as 2017 income to the extent the deduction reduced your 2016 taxable income (11.6).

If you do not discover the loss until a later year. In this case, IRS regulations do not specifically allow a deduction for the loss in the year it is discovered, but court decisions have. In one case, an unseasonable blizzard damaged a windbreak planted to protect a house, buildings, and livestock. The damage to the evergreens did not become apparent until the next year, when about half of the trees died and the others were of little value. The court held that the loss occurred in the later year. In another case, hurricane damage did not become apparent for two years. The Tax Court allowed the deduction in the later year. A deduction is generally not allowed for drought damage after the year in which the drought occurs (18.1).

Note that under special rules for Ponzi-scheme-related losses, the IRS does allow the deduction to be claimed in the “discovery” year (18.9).

If your loss is in a federal disaster area. If your property is damaged in an area eligible for federal disaster assistance, you have a choice of years for which the loss may be claimed (18.3).

If reimbursements exceed your adjusted basis for the property. Receiving reimbursements in excess of adjusted basis results in a gain that you must report on your return unless you acquire qualifying replacement property and elect to defer the gain (18.19). If a loss is claimed in one year and in a later year you receive reimbursements that exceed your adjusted basis, the gain is included in income for the later year to the extent the original deduction reduced your taxable income (11.6). The remainder of the gain is taxable unless you buy replacement property that enables you to defer the gain (18.19).

18.3 Disaster Losses

If you suffer a loss from a disaster in an area determined by the President as warranting federal assistance (under the Robert T. Stafford Disaster Relief and Emergency Assistance Act or successor law), you may deduct the loss (figured on Form 4684 under the regular casualty loss rules at 18.12 and 18.13) either on your return for the year of the disaster or on the return for the preceding year.

Election to deduct loss for the preceding year. You have until six months after the original due date (without extensions) for your return for the disaster year to make the prior-year election. Thus, for a 2017 disaster loss, you have until October 15, 2018, to claim the loss for 2016 (the year before the year of the disaster) by making the prior-year election on an amended return (Form 1040X) for 2016, assuming you have filed an original 2016 return.

To make the election on either an original return or amended return for the prior year, you must attach a statement, either on Form 4684 or on a separate attachment, that indicates that you are making the prior-year election under Code Section 165(i). The statement should describe or name the disaster (such as a named Hurricane) and give the date it occurred and the address of the damaged or destroyed property (Revenue Procedure 2016-53).

If you first claim the loss on your return for the year of the disaster and then decide to make the prior-year election, you must file an amended return for the disaster year to remove the deduction on or before the date you file the original or amended return for the preceding year that includes the prior-year election.

Revoking prior- year election. If you make the prior-year election, you may revoke it in order to deduct the loss on your return for the year of the disaster, provided the revocation is made on or before the date that is 90 days after the due date for making the election (see above). To revoke the election, you must file an amended return for the prior year to remove the disaster loss deduction on or before the date you file the return or amended return for the disaster year on which you are going to claim the loss. The amended return for the prior year must include a statement that specifically revokes the prior-year election, and that describes (or names) the disaster, gives the date it occurred and the address of the damaged or destroyed property.

Homeowners forced to relocate. If you were forced to relocate or demolish your home in a disaster area, you may be able to claim a loss even though the damage, such as from erosion, does not meet the sudden event test (18.1). For example, after a severe storm, there is danger to a group of homes from nearby mudslides. State officials order homeowners to evacuate and relocate their homes. Disaster loss treatment is allowed provided: (1) the President has determined that the area warrants federal disaster relief; (2) within 120 days of the President’s order, you are ordered by the state or local government to demolish or relocate your residence; and (3) the home was rendered unsafe by the erosion or other disaster. The law applies to vacation homes and rental properties, as well as to principal residences.

If these tests are met, the loss in value to your home is treated as a disaster loss so that you may elect to deduct the loss either in the year the demolition or relocation order is made or in the prior taxable year.

Fiscal year. If you are on a fiscal year, an election may be made to claim a disaster loss occurring after the close of a fiscal year on the return for that closed year. For example, if your fiscal year ends June 30, and you suffer a disaster loss at any time between July 1, 2016, and June 30, 2017, you may elect to deduct it on your return for the fiscal year ending June 30, 2016.

Disaster relief grants and loans. Cancellation of part of a federal disaster loan under the Robert T. Stafford Disaster Relief and Emergency Assistance Act is treated as a reimbursement that reduces your loss (18.16). If you receive a post-disaster grant under the Disaster Relief Act to help you meet medical, dental, housing, transportation, personal property, or funeral expenses, the grant is excludable from income. However, to the extent the grant specifically reimburses a casualty loss or medical expense (17.2), that expense is not deductible. Unemployment assistance payments under the Disaster Relief Act are taxable unemployment benefits (2.6).

Disaster grants for business property losses. Payments by the federal government or a state or local government to a business for property losses may not be excluded from business gross income. The IRS has ruled that the disaster relief exclusion that applies to government payments made to individuals to promote the general welfare does not apply to business property losses. The business realizes a taxable gain to the extent the grant exceeds the adjusted basis in the damaged or destroyed property, but that gain can be deferred under the involuntary conversion rules (18.19) by making a timely reinvestment of the payments in qualified replacement property. The replacement period for damaged or destroyed business property is two years (18.22).

IRS interest abatement. For declared disasters, the IRS will abate interest on taxes due for the period covered by an extension to file tax returns and pay taxes.

Insurance Proceeds for Damaged or Destroyed Residence

Destruction of principal residence and contents. Generally, you have a taxable gain if you receive insurance proceeds in excess of your adjusted basis for damaged or destroyed property (18.19). However, where your principal residence is destroyed, you may be able to exclude from gross income gains from the receipt of insurance proceeds under the $250,000 ($500,000 if married filing jointly) home sale exclusion (29.1). According to the IRS, a principal residence must be completely destroyed to qualify for the home sale exclusion; a partial destruction does not qualify. If a residence is damaged to the extent that the remaining structure must be deconstructed in order to rebuild, or the costs of repair substantially exceed the pre-disaster value of the home, the home is considered to have been completely destroyed, allowing the gain to be excluded from income subject to the $250,000/$500,000 exclusion limit. If the home sale exclusion is not available to you or if the gain exceeds your exclusion, the nonexcludable gain may be deferred under the involuntary conversion rules if you buy a replacement residence (18.19).

Gain may be minimized by special computation rules. Where your principal residence is damaged or destroyed in a federally declared disaster, favorable involuntary conversion rules eliminate tax on some of the gain and make it easier to defer the balance. These rules apply to renters as well as home owners.

1. Any gain on insurance proceeds received for “unscheduled” personal property in your principal residence (rented or owned) is not “recognized” by the tax law, so it is not taxable. Personal property is unscheduled if it is not separately listed on a schedule or rider to the basic insurance policy.
2. Insurance proceeds received for the home itself or for scheduled property are treated as received for a single item of property. Gain on this combined insurance pool may be deferred by reinvesting in replacement property that is similar or related in service or use to either the damaged residence or its contents. If the cost of a new principal residence and/or contents equals or exceeds the combined insurance pool, you may elect to defer any gain attributable to the insurance recovery (18.21) for making the election. The deferred gain reduces your basis in the replacement property. The period for purchasing replacement property ends four years after the end of the first tax year in which any part of your gain is realized. If the cost of the replacement property is less than the combined insurance pool, your gain is taxed to the extent of the unspent reimbursement.

Sale of land underlying destroyed principal residence or second home. If your principal residence is destroyed in a federally declared disaster, and you decide to relocate elsewhere and sell the underlying land, the IRS treats the sale and the destruction as a single involuntary conversion. If you have a gain that is not excludable under the home sale exclusion rules (Chapter 29), the land sale proceeds are combined with your insurance recovery for purposes of figuring deferrable gain under the involuntary conversion replacement rules (18.19). All of the gain resulting from the insurance recovery may be deferred if a new principal residence is purchased within the four-year replacement period and it costs at least as much as the combined insurance and sales proceeds. The replacement period ends four years after the close of the first year in which any part of your gain is realized.

The destroyed home does not have to be your principal residence or even be located in a federal disaster area for the above “single conversion” rule to apply. The rule applies to the destruction of a second residence such as a vacation home that qualifies for a mortgage interest deduction (15.1), However, the replacement period (18.22) for a second home is two years, whether or not it was in a federal disaster area. The two-year replacement period also applies for principal residences that were not located in a federal disaster area (rather than the four-year period allowed for principal residences within federal disaster areas).

18.4 Who May Deduct a Casualty Loss

A casualty loss deduction may be claimed only by the owner of the property. For example, a husband filing a separate return may not deduct damage to a car belonging to his wife; only she may deduct it on her separate return.

On jointly owned property, the loss is divided among the owners. If you and your spouse own the property jointly, you deduct the entire loss on a joint return. If you file separately, each owner deducts his or her share of the loss on each separate return.

If you have a legal life estate in the property, the loss is apportioned between yourself and those who will get the property after your death. The apportionment may be based on actuarial tables that consider your life expectancy.

You may claim a casualty loss for property lost or destroyed by your dependent if you own the property. You may not claim a loss deduction for destroyed property that belongs to your child who has reached majority, even though he or she is still your dependent.

Lessee. A person leasing property may be allowed to deduct payments to a lessor that are required under the lease to compensate for a casualty loss. A tenant was allowed to deduct as a casualty loss payment of a judgment obtained by the landlord for fire damage to the rented premises that had to be returned in the same condition as at the start of the lease. However, the Tax Court does not allow a deduction for the cost of repairing a rented car, as the lessee has no basis in the car.

18.5 Bank Deposit Losses

If a bank or other financial institution in which you deposit funds fails and your loss is not covered by insurance, generally you may claim your loss either as a bad debt deduction or casualty loss. Alternatively, if none of the deposits were federally insured, an investment loss may be claimed. A casualty loss deduction may not be claimed for lost deposits in foreign financial institutions that are not organized and supervised under federal or state law. Neither the casualty loss nor the investment loss option is available to stockholders of the bank with more than a 1% interest, officers of the bank, or relatives of shareholders or officers.

Bad debt. You may claim a bad debt deduction for a loss of a bank deposit in the year there is no reasonable prospect of recovery from the insolvent or bankrupt bank. You claim the loss as a short-term capital loss on Form 8949 and Schedule D (Form 1040) unless the deposit was made in your business. A nonbusiness bad debt deduction is deductible from capital gains. If you do not have capital gains or the bad debt loss exceeds capital gains, only $3,000 of the loss may offset other income. The remaining loss is carried over. A lost deposit of business funds is claimed as a business bad debt (5.33).

Casualty loss. You may elect to take a casualty loss deduction for the year in which the loss can be reasonably estimated. A loss of personal funds is subject to the $100/10% AGI floors for personal-use property losses (18.12). Once the casualty loss election is made, it is irrevocable and will apply to all other losses on deposits in the same financial institution.

The casualty loss election may allow you to claim the loss in an earlier year because you do not have to wait until the year there is no prospect of recovery as required in the case of bad debts. The casualty loss election may also be advisable if you have other casualty losses that absorb all or part of the 10% AGI floor.

Investment loss. If none of your deposits were federally insured and you reasonably estimate that you will not recover the funds, up to $20,000 ($10,000 if married filing separately) may be claimed on Schedule A (Form 1040) as an investment loss subject to the 2% of adjusted gross income floor for miscellaneous itemized deductions (19.1). The $20,000 limit (or $10,000) applies to total losses from any one financial institution, regardless of the number of accounts you have. A separate $20,000 deduction limit applies to each financial institution. The $20,000 (or $10,000) limit is reduced by any insurance proceeds authorized by state law that you reasonably expect to receive. If you claimed a bad debt deduction for a lost deposit in a prior year and you qualify for the investment loss, you may file an amended return to claim the investment loss if the statute of limitations has not passed.

Reasonable estimate of casualty or investment loss. Generally, the trustees of the troubled bank will provide depositors with an estimate of the expected recovery and loss. In the year of that determination, you may claim the estimated loss deduction. If you deduct an estimated loss that is less than you are entitled to, you may claim the additional loss in the year of the final determination as a bad debt. If you deduct more than the actual loss, the excess loss must be reported as income in the year of the final determination. Failure to claim the loss in the year in which the loss can first be reasonably estimated does not bar a deduction in a later year.

For any particular year, only one election may be made for losses in the same bank. If you elect the up-to-$20,000 investment loss for losses in one bank and your loss exceeds the limit, the balance may not be claimed as a casualty deduction. Similarly, if you elect casualty loss treatment, the amount that is not deductible because of the $100 and 10% of adjusted gross income floors (18.12) is not deductible under the $20,000 investment loss rule.

18.6 Damage to Trees and Shrubs

Not all damage to trees and shrubs qualifies as a casualty loss. The damage must be occasioned by a sudden event (18.1). Destruction of trees over a period of 5–10 days by southern pine beetles is deductible. One court allowed a deduction for similar destruction over a 30-day period. However, damage by Dutch Elm disease or lethal yellowing disease has been held to be gradual destruction not qualifying as a casualty loss. The Tax Court has allowed a deduction for the cost of removing infested trees, but denied a deduction for the loss of trees after a horse ate the bark.

If shrubbery and trees on personal-use property are damaged by a sudden casualty, you figure the loss on the value of the entire property before and after the casualty. You treat the buildings, land, and shrubs as one complete unit; see Example 2 below. In fixing the loss on business or income-producing property, however, shrubs and trees are valued separately from the building; see Example 1 below.

18.7 Deducting Damage to Your Car

Damage to your car in an accident may be a deductible casualty loss unless caused by your willful conduct, such as drunken driving.

You may not deduct legal fees and costs of a court action for damages or money paid for damages to another’s property because of your negligence while driving for commuting or other personal purposes. But if at the time of the accident you were using your car on business, you may deduct as a business loss a payment of damages to the other party’s car. For purposes of a business loss deduction, driving between two locations of the same business is considered business driving but driving between locations of two separate businesses is considered personal driving. Therefore, the payment of damages arising from an accident while driving between two separate businesses is not deductible as a business expense.

A court has allowed casualty deductions for damage resulting from a child starting a car and from flying stones while driving over a temporary road. In a private letter ruling, the IRS disallowed a loss for damage to a race car by an amateur racer on the ground that in races, crashes are not an unusual event and so do not constitute a casualty.

If the deduction is questioned, be prepared to show the amount, if any, of your insurance recovery. A deduction is allowed only for uninsured losses. Not only must the loss be proved, but also that it was not compensated by insurance.

Towing costs are not included as part of the casualty loss.

A parent may not claim a casualty loss deduction for damage to a car registered in a child’s name, although the parent provided funds for the purchase of the car.

Expenses of personal injuries arising from a car accident are not a deductible casualty loss.

Automobile used partly for business. When you use an automobile partly for personal use and partly for business, your loss is computed as though two separate pieces of property were damaged—one business and the other personal. The $100 and 10% floors (18.12) reduce only the loss on the part used for personal purposes.

18.8 Proving a Casualty Loss

If your return is audited, you will have to prove that the casualty occurred and the amount of the loss. The time to collect your evidence is as soon after the casualty as possible. Table 18-1, Proving a Casualty Loss, indicates the information that you will need when computing your loss (18.13).

18.9 Theft Losses

You can deduct a theft loss in the year you discover that your property was stolen. The taking of property must be illegal under state law to support a theft loss deduction. That property is missing is not sufficient evidence to sustain a theft deduction. It may have been lost or misplaced. So if all you can prove is that an article is missing or lost, your deduction may be disallowed. Sometimes, of course, the facts surrounding the disappearance of an article indicate that it is reasonable to assume that a theft took place. A deduction has been allowed for the theft of trees.

If you expect to be reimbursed by insurance, you must subtract the expected reimbursement when you figure your deductible loss (18.13).

A legal fee paid to recover stolen property has been held to be deductible as part of the theft loss. To figure the amount of a theft loss deduction, see 18.13.

Fraud by building contractors. A contractor’s misuse of a taxpayer’s funds is a deductible theft loss if the builder’s conduct constitutes a crime under state law; a criminal prosecution or conviction is not necessary to show there was a theft for tax deduction purposes. In one case, a deduction was allowed when a building contractor ran away 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 he advanced to the contractor and the value of the partially completed house. In another case, a theft deduction was allowed for payments to subcontractors. The main contractor had fraudulently claimed that he had paid them before he went bankrupt.

The Tax Court rejected a theft loss claim that a contractor who failed to meet the construction plan specifications for a home had committed fraud under New Mexico law. The job was completed and repairmen were sent by the contractor to fix defects even after the one-year warranty period had expired. The contractor may have acted negligently or committed breach of contract, but poor workmanship is not fraud.

Embezzlement losses. Losses from embezzlement are deductible as theft losses in the year the theft is discovered. However, if you report on a cash basis, you may not take a deduction for the embezzlement of income you have not reported. For example, an agent embezzled royalties of $46,000 due an author. The author’s theft deduction was disallowed. The author had not previously reported the royalties as income; therefore, she could not get the deduction.

Stock bought on the open market. The IRS does not allow a theft loss if you buy stock on the open market and some or all of your investment is lost because of the fraudulent activities of corporate officers or directors. Your loss is a capital loss (5.4), not a theft loss. There is no theft in this situation because there is no direct connection between the corporate wrongdoers and the investors, and the officers and directors lacked a specific criminal intent to take the shareholders’ funds.

The IRS contrasts such open market transactions with Ponzi-type fraudulent schemes, in which it holds there is a criminal intent to target the investors, and thus a theft loss is allowed for such Ponzi-scheme losses; see below.

Deduction allowed to victims of Ponzi schemes and similar fraudulent schemes. The IRS allows investors who fall victim to fraudulent investment arrangements, including Ponzi schemes, to claim a theft loss deduction under special rules (Revenue Ruling 2009-9). A theft loss is deductible for the year the loss is discovered. The loss is considered a “theft,” not a capital loss, as it is the result of a criminal fraudulent scheme intended to deprive investors of the funds they invested. Since the loss is to their investment account (transaction entered into for profit), the floors for personal-use property in 18.12 do not apply. The deductible theft loss includes the investments made in the fraudulent arrangement and any interest, dividends and capital gains from the scheme that were reported on prior-year tax returns and reinvested, minus any withdrawals. If in the year the loss is discovered the investor has a reasonable prospect of reimbursement, the deductible amount is reduced by the expected reimbursement.

Recognizing that it could be difficult to determine when and how much to deduct as a Pozi-scheme loss, the IRS provides certain taxpayers with an optional safe harbor method, discussed below, for computing and reporting the theft loss(Revenue Procedure 2009-20).

If you are eligible for and choose to use the IRS safe harbor, first complete Section C of Form 4684, and then enter the deductible amount from Section C on Section B. If you cannot use the safe harbor, or choose not to, just complete Section B of Form 4684.

Safe harbor. The safe harbor allows eligible investors to deduct either 75% or 95% of their “qualified investment,” less any actual or projected recovery from insurance, loss-protection arrangement, or the SIPC (Securities Investor Protection Corporation). The 75% deduction applies if the investor intends to pursue a third-party recovery, and the 95% deduction applies if a third-party recovery will not be pursued. If in a later year there is a recovery that exceeds the non-deducted 5% or 25% portion of the loss, the recovery is taxable under the tax benefit rule (11.6) to the extent of the safe harbor deduction (Revenue Procedure 2009-20).

Eligibility for the safe harbor is limited to investors who had a taxable investment account in the fraudulent arrangement and the investment must have been made directly, not through a fund, partnership, or other entity. Losses in IRAs or other tax-deferred retirement plans invested with the scheme do not qualify for the safe harbor.

A loss is eligible for safe harbor relief only if (1) the “lead figure” in the scheme was charged under federal or state law (by way of indictment or information) with fraud, embezzlement, or a similar crime, or (2) in response to a federal or state criminal complaint, the lead figure admitted guilt or a receiver or trustee was appointed or the assets were frozen, or (3) the assets of the investment scheme were frozen or a receiver or trustee was appointed after a state or federal agency filed a civil complaint in a court or administrative proceeding alleging a fraudulent arrangement conducted by the lead figure, and the lead figure died before being charged with criminal theft.

The loss is deductible for the taxable year in which the theft was discovered (the “discovery year”). Generally, this is the year in which the indictment, information, or complaint against the lead figure was filed. However, if the lead figure died before being charged with criminal theft and a civil complaint under (3) above was filed, the discovery year is the year of the lead figure’s death where that is later than the year that the civil complaint was filed (Revenue Procedure 2011-58). In one case, a civil complaint under (3) above was filed against several lead figures, and in that same year, a receiver was appointed and one of the lead figures died before being criminally charged. In the following year, criminal charges were brought against another lead figure. The IRS ruled that the “year of discovery” for claiming the safe harbor loss was the first year, the year in which the civil complaint was filed, one of the lead figures died before being criminally charged, and a receiver was appointed, rather than in the second year in which criminal charges were brought against one of the lead figures.

Fraudulent sales offers. Worthless stock purchases made on the representation of false and fraudulent sales offers are deductible as theft losses in the year there is no reasonable prospect of recovery. However, the illegal sale of unregistered stock does not support a theft loss deduction. In addition, buying stock from a bad tip and losing money is not deductible.

Kidnapping ransom. Payment of ransom to a kidnapper is generally a deductible theft loss. However, the expense of trying to find an abducted child is not a theft loss.

Fortune tellers. The Tax Court allowed a theft loss deduction in New York, where fortune telling is by law a theft-related offense. The law assumes that telling fortunes or promising to control occult forces is a form of fraud. An exception is made for fortune telling at shows for the purpose of entertaining or amusement. That a person voluntarily asks for advice does not bar the deduction. According to the court, a gullible person who gives money to fortune tellers in the belief that he or she will be helped is still defrauded or swindled. Theft is a broad term and includes theft by swindling, false pretenses, and any other form of guile. In this case, the taxpayer, who was suffering from depression, had become attached to two fortune tellers whom he claimed took him for over $19,000.

Riot losses. Losses caused by fire, theft, and vandalism occurring during riots and civil disorders are deductible. To support your claim of a riot loss, keep evidence of the damage suffered and the cost of repairs. Photographs taken prior to repairs or replacement, lists of damaged or missing property, and police reports would help to establish and uphold your loss deduction.

Foreign government confiscations. The IRS and courts have disallowed casualty deductions for confiscations of personal property by foreign governments. This includes deposits in foreign banks; the loss is limited to a short-term capital loss.

Swindled by friend. A theft loss deduction was allowed to a widow who gave her old beau over $2 million to acquire stock for her in his bank. He used the money to pay his personal debts. The IRS barred the theft loss, arguing that the widow failed to prove fraud. A district court disagreed and allowed the deduction. Under Oklahoma state law, a person who makes a promise in return for cash has committed larceny by fraud if he never intended to return the funds or make good on the promise. Here, that the widow gave him the money voluntarily does not bar a theft loss deduction. She parted with the funds based upon his false claim that he would invest the money for her when he had no intention of doing so, but planned all along to pay off his debts with the funds.

18.10 Proving a Theft Loss

Get statements from witnesses who saw the theft or police records documenting a break-in to your house or car. A newspaper or online account of the crime might also help.

When you suspect a theft, make a report to the police. Even though your reporting does not prove that a theft was committed, it may be inferred from your failure to report that you were not sure that your property was stolen. But a theft loss was allowed where the loss of a ring was not reported to the police or an attempt made to demand its return from the suspect, a domestic employee. The owner feared being charged with false arrest.

18.11 Nondeductible Casualty and Theft Losses

Review the rules (18.1, 18.9) to make sure you have a deductible casualty or theft. Certain losses, though “casualties” for you, may not be deducted if they are not due to theft, fire, or from some other sudden natural phenomenon. The following have been held to be nondeductible losses:

• Termite damage (18.1)
• Carpet beetle damage
• Dry rot damage
• Damages for personal injuries or property damage to others caused by your negligence
• Legal expenses in defending a suit for your negligent operation of your personal automobile
• Legal expenses to recover personal property wrongfully seized by the police
• Expenses of moving to and rental of temporary quarters
• Loss of personal property while in storage or in transit
• Loss of passenger’s luggage put aboard a ship. The passenger missed the boat and the luggage could not be traced.
• Accidental loss of a ring from your finger
• Injuries resulting from tripping over a wire
• Loss by husband of joint property taken by his wife when she left him
• Loss of a valuable dog (or family pet) that strayed and was not found
• Steady weakening of a building due to normal wind and weather conditions
• Damage to a crop caused by plant diseases, insects, or fungi
• Damage to property from drought in an area where a dry spell is normal and usual
• Damage to property caused by excavations on adjoining property
• Damage from rust or corroding of understructure of house
• Moth damage
• Dry well
• Losses occasioned by water pockets, erosion, inundation at still water levels, and other natural phenomena (there was no sudden destruction.)
• Death of a saddle horse after eating a silk hat
• A watch or spectacles dropped on the ground
• Sudden drop in the value of securities
• Loss of contingent interest in property due to the unexpected death of a child
• Improper police seizure of private liquor stock
• Chinaware broken by a family pet
• Temporary fluctuation of property value
• Damage to property from local government construction project
• Fire purposely set by owner
• Engine damage due to failure to use antifreeze

Note: Some of the above items may be allowed as business expenses.

18.12 Floors for Personal-Use Property Losses

Casualty and theft losses attributable to personal-use property are subject to “floors” that will reduce, and in some cases eliminate, your deduction on Form 4684. Each casualty or theft loss (Steps 1–4 at 18.13) on personal-use property must be reduced by $100, and then the net loss for the year on all items of personal-use property is further reduced by 10% of your adjusted gross income (Step 5 at 18.13). However, different rules apply to qualifying losses from Hurricanes Harvey, Irma, and Maria; see the Law Alert on this page.

$100 floor for each loss. Each casualty or theft loss of property used for personal purposes is reduced by $100. The $100 floor does not apply to losses of business property or property held for the production of income such as securities. If property used in personal activities as well as for business or investment is damaged, the $100 offset applies only to the loss allocated to personal use.

For each personal casualty or theft, a separate $100 reduction applies. For example, if you are involved in five different casualties during 2017, there will be a $100 offset applied to each of the five losses. But when two or more items of property are destroyed in one event, only one $100 offset is applied to the total loss. For example, a storm damages your residence and also your car parked in the driveway. You figure the loss on the residence and car separately on Form 4684, but only one $100 offset applies to the total loss.

The $100 floor is applied after taking into account insurance proceeds received and insurance you expect to receive in a later year.

The $100 floor applies separately to the loss of each individual whose property has been damaged by a single casualty, even where the damaged property is owned by two or more individuals. The only exception is for a married couple filing jointly who apply only one $100 floor to their losses from a single casualty.

10% AGI floor. The 10% adjusted gross income (AGI) floor reduces your deduction for net casualty and theft losses realized during the year on personal-use property. If you have gains as well as losses from casualties and thefts on personal-use property, and the total loss (after the $100 floor reduces each casualty/theft loss) exceeds the total gain, the net loss is reduced by 10% of your AGI. The Example below illustrates the application of the $100 floor to each separate casualty event and the 10% AGI floors.

18.13 Figuring Your Loss on Form 4684

Form 4684 is used to report casualties or thefts of personal-use property, business property, or income-producing property. The deductible loss is usually the difference between the fair market value of the property before the casualty or theft and the fair market value after the casualty or theft but this loss in value must be reduced by (1) reimbursements received for the loss and (2) if the property was used for personal purposes, by the $100 floor (18.12). However, the loss may not exceed your adjusted basis (5.20) for the property, which for many items will be your cost. If your adjusted basis is less than the loss in value, your deduction is limited to basis, less reimbursements and the $100 floor for personal-use assets. After figuring all allowable casualty and theft losses and gains for personal-use property, the net loss (losses in excess of gains if any) is deductible as an itemized deduction on Schedule A (Form 1040) only to the extent it exceeds the 10% adjusted gross income (AGI) floor (18.12). A net loss from business property is not claimed as an itemized deduction; the loss from Form 4684 is entered on Form 4797. New law: See Step 5 below for special hurricane disaster loss rules.

Steps for calculating your deductible loss for 2017. The following five steps reflect the procedure on Form 4684 for computing a casualty or theft loss. If your loss is to business inventory, you do not have to use Form 4684, but may take the loss into account when figuring the cost of goods sold; see “Inventory losses” later in this section.

Business losses. Losses from business property are generally netted against gains from casualties or thefts on Form 4684 and the net gain or loss is entered on Form 4797. Follow the instructions to Form 4684.

Inventory losses. A casualty or theft loss of inventory is automatically reflected on Schedule C in the cost of goods sold, which includes the lost items as part of your opening inventory. Any insurance or other reimbursement received for the loss must be included as sales income.

You may separately claim the inventory loss as a casualty or theft loss on Form 4684 instead of automatically claiming it as part of the cost of goods sold. If you do this, you must eliminate the items from inventory by lowering either opening inventory or purchases when figuring the cost of goods sold.

Cost less depreciation method for household items. The Tax Court has allowed casualty loss deductions based on cost less depreciation, rather than on the difference in fair market value immediately before and after the casualty. See the following Example.

18.14 Personal and Business Use of Property

For property held partly for personal use and partly for business or income-producing purposes, a casualty or theft loss deduction is computed as if two separate pieces of property were damaged, destroyed, or stolen. Follow the steps for figuring the allowable loss (18.13), but apply the $100 and 10% of adjusted gross income floors only to the personal part of the loss.

18.15 Repairs May Be a “Measure of Loss”

The cost of repairs may be treated as evidence of the loss of value (Step 1 (18.13)), if the amount is not excessive and the repairs do nothing more than restore the property to its condition before the casualty. An estimate for repairs will not suffice; only actual repairs may be used as a measure of loss. However, where you measure your loss by comparing appraisals of value for before and after the casualty, repairs may be considered in arriving at a post-casualty value even though no actual repairs are made.

Deduction not limited to repairs. A casualty loss deduction is not limited to repair expenses where the decline in market value is greater, according to a federal appeals court; see the following Example.

18.16 Insurance Reimbursements

You reduce the amount of your loss (18.13) by insurance proceeds, voluntary payments received from your employer for damage to your property, and cash or property received from the Red Cross. Also reduce your loss by reimbursements you expect to receive in a later year (18.2). However, cash gifts from friends and relatives to help defray the cost of repairs do not reduce the loss where there are no conditions on the use of the gift. Also, gifts of food, clothing, medical supplies, and other forms of subsistence do not reduce the loss deduction nor are they taxable income.

Cancellation of part of a disaster loan under the Disaster Relief Act is treated as a partial reimbursement of the loss and reduces the amount of the loss. Payments from an urban renewal agency to acquire your damaged property under the Federal Relocation Act of 1970 are considered reimbursements reducing the loss.

Insurance payments for the cost of added living expenses because of damage to a home do not reduce a casualty loss. The payments are treated as separate and apart from payments for property damage. Payments for excess living costs are generally not taxable (18.17).

Passive activity property loss reimbursements. A reimbursement of a casualty or theft loss deduction is not considered passive activity income if the original loss was not treated as a passive deduction (10.1). The reimbursement may be taxed (11.6).

Realizing a gain from insurance. If you receive insurance proceeds in excess of your adjusted basis for the property, you generally realize a gain, which you may be able to defer by buying replacement property (18.19).

18.17 Excess Living Costs Paid by Insurance Are Not Taxable

Your insurance contract may reimburse you for excess living costs when a casualty or a threat of casualty forces you to vacate your house. The payment is fully or partially tax free if these tests are met:

1. Your principal residence is damaged or destroyed by fire, storm, or other casualty or you are denied use of it by a governmental order because of the occurrence or threat of the casualty.
2. You are paid under an insurance contract for living expenses resulting from the loss of occupancy or use of the residence.

Tax-free reimbursements. Whether you have a taxable or tax-free reimbursement is figured at the end of the period you were unable to use your residence. Thus, if the dislocation covers more than one taxable year, the taxable income, if any, will be reported in the taxable year in which the dislocation ended.

The tax-free amount is limited to the excess living costs paid by the insurance company. The excess is the difference between (1) the actual living expenses incurred during the time you could not use or occupy your house and (2) the normal living expenses that you would have incurred for yourself and members of your household during the period. Insurance payments that exceed (1) minus (2) are generally taxable; see the Examples below. However, the insurance payments are completely tax free if the temporary increase in your living costs was due to a casualty in a federal disaster area; qualified disaster area relief payments are not taxable (18.3).

Living expenses during the period may include the cost of renting suitable housing and extraordinary expenses for transportation, food, utilities, and miscellaneous services. The expenses must be incurred for items and services (such as laundry) needed to maintain your standard of living that you enjoyed before the loss and must be covered by the policy.

Where a lump-sum settlement does not identify the amount covering living expenses, an allocation is required to determine the tax-free portion. In the case of uncontested claims, the tax-free portion is that part of the settlement that bears the same ratio to total recovery as increased living expense bears to total loss and expense. If your claim is contested, you must show the amount reasonably allocable to increased living expenses consistent with the terms of the insurance contract, but not in excess of coverage limitations specified in the contract.

The exclusion from income does not cover insurance reimbursements for loss of rental income or for loss of or damage to real or personal property; such reimbursements for property damage reduce your casualty loss (18.16).

If your home is used for both residential and business purposes, the exclusion does not apply to insurance proceeds and expenses attributable to the nonresidential portion of the house. There is no exclusion for insurance recovered for expenses resulting from governmental condemnation or order unrelated to a casualty or threat of casualty.

The insurance reimbursement may cover part of your normal living expenses as well as the excess expenses due to the casualty. The part covering normal expenses is income; it does not reduce your casualty loss.

18.18 Do Your Casualty or Theft Losses Exceed Your Income?

If your 2017 casualty or theft losses exceed your income for the year, you pay no tax for 2017. Under the net operating loss (NOL) rules (40.18), you may carry back the excess casualty or theft loss three years and forward 20 years. Thus, an excess casualty or theft loss for 2017 can be carried back three years to 2014 and you can claim a refund for that year. Any balance of the 2017 loss (not applied to 2014) can be carried back to 2015 and 2016 and then forward 20 years to 2018 through 2037.

The $100 floor (18.12) and the 10% of adjusted gross income floor (18.12) for personal casualty or theft losses apply only in the year of the loss; you do not again reduce your loss in the carryback or carryforward years.

18.19 Defer Gain by Replacing Property

If your property is destroyed, damaged, stolen, or seized or condemned by a government authority, this is considered to be an involuntary conversion for tax purposes. If upon an involuntary conversion you receive insurance or other compensation that exceeds the adjusted basis of the property, you realize a gain that is taxable unless you may defer gain (18.20–18.24) or, in the case of a principal residence, you may exclude gain under the rules in Chapter 29.

You may elect to postpone tax on the full gain provided you invest the proceeds in replacement property the cost of which is equal to or exceeds the net proceeds from the conversion (18.24). Buying a replacement from a related party generally qualifies only if your gains from involuntary conversions are $100,000 or less (18.23). Gain realized on a destroyed or condemned principal residence that exceeds the allowable exclusion under the rules in Chapter 29 may be postponed by reinvesting at least the conversion proceeds minus the excluded gain (18.20–18.24).

The replacement period (18.22) is two years for personal-use property; for business and investment property it is two or three years depending on the type of involuntary conversion (18.22); for a principal residence and its contents involuntarily converted due to a federally declared disaster (18.3) it is four years. If you find that you cannot buy a replacement by the end of the period, ask the IRS for an extension of time. See 18.22 for further replacement period details.

Basis in replacement property. Your basis in the replacement property is its replacement cost, minus any postponed gain.

18.20 Involuntary Conversions Qualifying for Tax Deferral

For purposes of an election to defer tax on gains, “involuntary conversion” is more broadly defined than “casualty loss.” You have an involuntary conversion when your property is:

Damaged or destroyed by some outside force, or stolen.

Seized, requisitioned, or condemned by a governmental authority. If you voluntarily sell land made useless to you by the condemnation of your adjacent land, the sale may also qualify as a conversion. Condemnation of property as unfit for human habitation does not qualify. Condemnation, as used by the tax law, refers to the taking of private property for public use, not to the condemnation of property for noncompliance with housing and health regulations. Similarly, a tax sale to pay delinquent taxes is not an involuntary conversion.

Sold under a threat of seizure, condemnation, or requisition. The threat must be made by an authority qualified to take property for public use. A sale following a threat of condemnation made by a government employee is a conversion if you reasonably believe he or she speaks with authority and could and would carry out the threat to have your property condemned. If you learn of the plan of an imminent condemnation from a newspaper or other news media, the IRS requires you to confirm the report from a government official before you act on the news.

Farmers. Farmers also have involuntary conversions when:

Land is sold within an irrigation project to meet federal acreage limitations ;

Cattle are destroyed by disease or sold because of disease; or

Draft, breeding, or dairy livestock is sold because of drought. The election to treat the sale as a conversion is limited to livestock sold over the number that would have been sold but for the drought.

In some cases, livestock may be replaced with other farm property where there has been soil or other environmental contamination.

Should you elect to postpone gain? An election gives an immediate advantage: tax on gain is postponed and the funds that would have been spent to pay the tax may be used for other investments.

However, as a condition of deferring tax, the basis of the replacement property is generally fixed at the same adjusted basis as the converted property. If your reinvestment exceeds the insurance proceeds, the excess increases the basis of the replacement property. As long as the value of the replacement property does not decline, tax on the original gain is finally incurred when the property is sold.

If your home was destroyed in a federally declared disaster area, and you have a gain that is not excludable under the home exclusion rules (Chapter 29), the gain may be excludable or deferrable under the special rules discussed in 18.3 under the heading “Insurance Proceeds for Damaged or Destroyed Residence.”

18.21 How To Elect To Defer Tax

To defer tax on your gain, do not report the gain as income for the year it is realized. Attach to your return a statement giving details of the involuntary conversion, including computation of the gain and your intention to buy a replacement if you have not yet done so. See the discussion of replacement periods and IRS notification requirements (18.22).

If your property is condemned and you are given similar property, no election is necessary. Postponement of tax on the gain is required. For example, the city condemns a store building and gives you another store building the value of which exceeds the cost basis of the old one; gain is not taxed.

Partnerships. The election to defer gain must be made at the partnership level. Individual partners may not make separate elections unless the partnership has terminated, with all partnership affairs wound up. Dissolution under state law is not a termination for tax purposes.

18.22 Time Period for Buying Replacement Property

To defer tax, you generally must buy property similar or related in use (18.23) to the converted property within a fixed time period. The replacement period is either two, three, or four years:

1. A two-year replacement period applies for destroyed, damaged, or stolen property, whether used for business, investment, or personal purposes, but there is a four-year period for principal residences in federally declared disaster areas (18.3). The two-year period for damaged, destroyed, and stolen property starts on the date the property was destroyed, damaged, or stolen, and ends two years after the end of the first year in which any part of your gain is realized. A two-year period also applies to a condemned residence.
2. A three-year replacement period applies for condemned business or investment real estate, excluding inventory. However, the two-year and not the three-year period applies if the condemned business or investment real estate is replaced by your acquiring control of a corporation that owns the replacement property.
3. A four-year replacement period applies for a principal residence or its contents involuntarily converted as a result of a federally declared disaster (18.3). The four-year replacement period starts on the date the residence is involuntarily converted and ends four years after the end of the first taxable year in which any part of the gain is realized.
4. A four-year replacement period for farmers and ranchers who are forced to sell livestock due to drought, flooding, or other weather conditions in areas eligible for federal assistance. Gain on such a forced sale may be deferred by buying replacement livestock within four years after the end of the first taxable year in which any part of the gain is realized. The IRS may extend the four-year replacement period on a regional basis if the weather conditions persist for more than three years. If the IRS allows an extension, it is announced in a Notice that lists the qualifying counties.

Replacing condemned property. For condemnations, the replacement period starts on the earlier of (1) the date you receive notification of the condemnation threat or (2) the date you dispose of the condemned property. Depending on the replacement period (see above), the period ends two, three, or four years after the end of the first year in which any part of the gain on the condemnation is realized. You may make a replacement after a threat of condemnation. If you buy property before the actual threat, it will not qualify as a replacement even though you still own it at the time of the actual condemnation.

Advance payment of award. Gain is realized in the year compensation for the converted property exceeds the basis of the converted property. An advance payment of an award that exceeds the adjusted basis of the property starts the running of the replacement period.

An award is treated as received in the year that it is made available to you without restrictions, even if you contest the amount.

Replacement by an estate. A person whose property was involuntarily converted may die before he or she makes a replacement. According to the IRS, his or her estate may not reinvest the proceeds within the allowed time and postpone tax on the gain. The Tax Court rejects the IRS position and has allowed tax deferral where the replacement was made by the deceased owner’s estate. However, the Tax Court agreed with the IRS that a surviving spouse’s investment in land did not defer tax on gain realized by her deceased husband on an involuntary conversion of his land. She had received his property as survivor of joint tenancy and could not, in making the investment, be considered as acting for his estate.

Giving IRS notice of replacement. Attach a statement to your return for the year you realize the gain. Include a description of the involuntary conversion, the amount of insurance or other reimbursement received, and how you figured the gain. If you have already acquired replacement property when you file your return for the year of the gain, the statement should describe the replacement property, its cost and its basis (replacement cost minus deferred gain), the amount of gain deferred, and if not all of the gain is deferred, the gain being reported as income.

If you have not bought replacement property by the time you file your return for the year of the gain but you intend to do so, attach a statement to your return describing the conversion and the computation of gain, and state that you intend to make a timely replacement. Then, on the return for the year of replacement, attach a statement giving the details of your replacement property. This notice starts the running of the three-year period of limitations during which the IRS can assess tax on the gain. Failure to give notice keeps the period open. Similarly, a failure to give notice of an intention not to replace also keeps the period open. If you do not buy replacement property after making an election to postpone tax on the gain, file an amended return for the year in which gain was realized and pay the tax (if any) on the gain.

Assume you have a gain from an involuntary conversion and do not expect to reinvest the proceeds. You report the gain and pay the tax. In a later year, but within the prescribed time limits, you buy similar property. On an amended return, you may make an election to defer tax on the gain and claim a refund for the tax paid in the earlier year on the gain.

18.23 Types of Qualifying Replacement Property

Although exact duplication is not required, the replacement generally must be similar or related in service or use to the property that was involuntarily converted in order to defer tax. Where real property held for productive use in a business or for investment is converted through a condemnation or threat of condemnation, the replacement test is more liberal. A replacement merely has to be of a like kind to the converted property.

Under the like-kind test for condemned real estate, a replacement with other real estate qualifies. Improved real property may be replaced by unimproved real property (6.1). Foreign and U.S. real property are considered to be of like kind for purposes of replacing condemned property, even though under the like-kind exchange rules (6.1), U.S. real estate and foreign real estate are not considered like-kind property.

Under the related in service or use test, the replacement of unimproved land for improved land does not qualify. A replacement generally must be closely related in function to the destroyed property. For example, a condemned personal residence must be replaced with another personal residence. The replacement of a house rented to a tenant with a house used as a personal residence does not qualify for tax deferral; the new house is not being used for the same purpose as the condemned one. This functional test, however, is not strictly applied to conversions of rental property. Here, the role of the owner toward the properties, rather than the functional use of the buildings, is reviewed. If an owner held both properties as investments and offered similar services and took similar business risks in both, the replacement may qualify.

You may own several parcels of property, one of which is condemned. You may want to use the condemnation award to make improvements on the other land such as drainage and grading. The IRS generally will not accept the improvements as a qualified replacement. However, an appeals court has rejected the IRS approach in one case.

If it is not feasible to reinvest the proceeds from the conversion of livestock because of soil contamination or other environmental contamination, then other property (including real property) used for farming purposes is treated as similar or related and qualifies as replacement property.

Deferral may be barred when buying a replacement from a relative. The gain deferral rules do not apply if you buy a replacement from a close relative or a related business organization unless the total gain you realized for the year on all involuntary conversions on which there are realized gains is $100,000 or less. In determining whether gains exceed $100,000, gains are not offset by losses. Affected related parties are the same as defined for loss transactions discussed in 5.6.

Buying controlling interest in a corporation. The replacement test may be satisfied by purchasing a controlling interest (80%) in a corporation owning property that is similar or related in service to the converted property.

Business and investment property in a disaster area. The similar or related-use tests do not have to be met when replacing business or investment property damaged or destroyed in a federally declared disaster area. You may make a qualified replacement by buying any tangible property held for business use; the replacement does not have to be in the federally declared disaster area.

18.24 Cost of Replacement Property Determines Postponed Gain

To fully defer tax on the replacement of involuntarily converted property (18.20), the cost of the replacement property must be equal to or exceed the net proceeds from the conversion. If replacement cost is no more than the adjusted basis of the converted property, you must include the entire gain in your income. If replacement cost is less than the amount realized on the conversion but more than the basis of the converted property, the difference between the amount realized and the cost of the replacement must be reported as a taxable gain; you may elect to postpone tax on the balance of the gain. See Examples 1–3 below.

Condemnation award. The award received from a state authority may be reduced by expenses of getting the award such as legal, engineering, and appraisal fees. The treatment of special assessments and severance damages received when part of your property is condemned is explained below (18.25). Payments made directly by the authority to your mortgagee may not be deducted from the gross award.

Do not include as part of the award interest paid on the award for delay in its payment; you report the interest as interest income. The IRS may treat as interest part of an award paid late, even though the award does not make any allocation for interest.

Relocation payments are not considered part of the condemnation award and are not treated as taxable income to the extent that they are spent for purposes of relocation; they increase basis of the newly acquired property.

Distinguish between insurance proceeds compensating you for loss of profits because of business interruption and those compensating you for the loss of property. Business interruption proceeds are fully taxed as ordinary income and may not be treated as proceeds of an involuntary conversion.

A single standard fire insurance policy may cover several assets. Assume a fire occurs, and in a settlement the proceeds are allocated to each destroyed item according to its fair market value before the fire. In comparing the allocated proceeds to the tax basis of each item, you find that on some items, you have realized a gain; that is, the proceeds exceed basis. On the other items, you have a loss; the proceeds are less than basis. According to the IRS, you may elect to defer tax on the gain items by buying replacement property. You do not treat the proceeds paid under the single policy as a unit, but as separate payments made for each covered item.

18.25 Special Assessments and Severance Damages

When only part of a property parcel is condemned for a public improvement, the condemning authority may:

1. Levy a special assessment against the remaining property, claiming that it is benefited by the improvement. The authority usually deducts the assessment from the condemnation award.
2. Grant an award for severance damages if the condemnation of part of your property causes a loss in value or damage to the remaining property that you keep.

A special assessment that is taken out of the award reduces the amount of the gross condemnation award. An assessment levied after the award is made may not be deducted from the award.

When both the condemnation award and severance damages are received, the condemnation is treated as two separate involuntary conversions: (1) A conversion of the condemned land. Here, the condemnation award is applied against the basis of the condemned land to determine gain or loss on its conversion; and (2) a conversion of part of the remaining land in the sense that its utility has been reduced by condemnation, for which severance damages are paid.

Net severance damages reduce the basis of the retained property. Net severance damages are the total severance damages, reduced by expenses in obtaining the damages and by any special assessment withheld from the condemnation award. If the damages exceed basis, gain is realized. Tax may be deferred on the gain through the purchase of replacement property under the “similar or related in service or use” test (18.23), such as adjacent land or restoration of the property to its original condition.

Allocating the proceeds between the condemnation award and severance damages will either reduce the gain or increase the loss realized on the condemned land. The IRS will allow such a division only when the condemnation authority specifically identifies part of the award as severance damage in the contract or in an itemized statement or closing sheet. The Tax Court, however, has allowed an allocation in the absence of earmarking where the state considered severance damages, and the value of the condemned land was small in comparison to the damages suffered by the remaining property. To avoid a dispute with the IRS, make sure the authority makes this breakdown. Without such identification, the IRS will treat the entire proceeds as consideration for the condemned property.

18.26 Reporting Gains From Casualties

If an involuntary conversion was the result of a theft or casualty, you have to prepare Form 4684. To report net gains, Form 4684 will direct you to Form 1040, Schedule D, or Form 4797, depending on the type of property involved. Generally, use of Form 4797 reflects the netting requirements for involuntary conversions of business, rental, or royalty property under Section 1231 (44.8).

If the conversion occurred because of a condemnation, you use Form 4797 for business or investment property and Form 8949 and Schedule D for personal-use property.