Safe-Harbor Methods for Claiming Casualty and Theft Losses from 2005 Gulf Hurricanes

Congress and the IRS have relaxed the rules for deducting casualty losses for victims of the 2005 Gulf hurricanes (i.e., Katrina, Rita and Wilma). The Robert T. Stafford Disaster Relief and Emergency Assistance Act suspends the limits on personal casualties imposed by Sec. 165(h); see Secs. 1400M and 1400S. In Rev. Proc. 2006-32, the Service offered alternative methods in calculating the deductible loss. Tax practitioners with clients in Alabama, Florida, Louisiana, Mississippi and Texas should familiarize themselves with this procedure.

Background

Generally, to determine the deductible loss under Sec. 165(a), Regs. Sec. 1.165-7(a)(2)(i) provides that the fair market value (FMV) of the property immediately before and immediately after the casualty generally shall be ascertained by competent appraisal. Rev. Proc. 2006-32 provides safe harbors for individuals who want to use this provision to determine the (1) decrease in the FMV of their personal-use residential real property and (2) pre-hurricane FMV of personal belongings. The procedure provides three safe-harbor methods that permit individuals to calculate the decrease in FMV of their personal residences and one safe-harbor method that allows individuals to calculate the decrease in FMV of their personal belongings.

Insurance Safe Harbor

Under this method, taxpayers can calculate the decrease in the FMV of their personal residence by relying on reports prepared by their flood or homeowners’ insurance company.

Contractor Safe Harbor

Under this method, taxpayers can use the contract price for repairs to their residence to determine the decrease in FMV of their personal residence. The price for repairs needs to be specified in an itemized contract (signed by the contractor and individual) made in accordance with local or state specifications. The contract should describe the costs to restore the residence to its pre-hurricane condition. However, the cost of work done to enhance the value of the residence over its pre-hurricane value must be excluded from the contract price.

Cost Indexes Safe Harbor

This method allows taxpayers to use one or more of the indexes provided in Rev. Proc. 2006-32, Section 4.04, to calculate the decrease in the residence’s FMV. The indexes provide a dollar value per square foot of specific damage categories (e.g., total loss, near-total loss, interior flooding, structural damage or roof damage). The loss is then computed based on the above-specified damage category and the square footage of the affected property. This method can only be applied to a personal residence, detached structures and wood decking. The loss determined under this method must be reduced by the value of any no-cost repairs (i.e., work done by volunteers or via donations).

Personal Belongings Safe Harbor

Individuals are also provided with a safe harbor to calculate the value of their personal belongings immediately before a 2005 hurricane, to determine a loss. Under this method, the taxpayer must first determine the replacement cost of the personal belongings, then reduce it by 10% for each year the item was owned. This method cannot be used for any item that maintains or increases in value over time.

Effective Dates

Rev. Proc. 2006-32 is effective for losses that arose in the Hurricane (1) Katrina disaster area after Aug. 24, 2005; (2) Rita disaster area after Sept. 22, 2005; and (3) Wilma disaster area after Oct. 22, 2005.

According to the procedure, the Service will not challenge an individual’s calculations of the decrease in FMV or pre-hurricane value if the individual qualifies and uses one of the safe-harbor methods. In addition, a taxpayer need not use a safe-harbor method; he or she may use the actual reduction in FMV of the residence or personal belongings, if the losses can be adequately and properly substantiated.

Reporting

Individuals who use one of the safe-harbor methods should attach a statement to Form 4864, Casualties and Thefts, stating that the loss was determined in accordance with Rev. Proc. 2006-32, and list the specific safe-harbor method used (along with the applicable table number(s), if the cost indexes method was used).

From Bernard Fleishman, CPA, and Frank Brodnax, CPA, Ellin & Tucker, Chartered, Baltimore, MD