Disasters are always bad news. Fires, floods, freezes, and other disasters can damage or destroy the personal or real property you use to keep your business up and running. However, you may be able to deduct your losses. And you are not subject to many of the restrictions that apply to deductions for disaster losses to personal property such as your home, personal car, or personal belongings.
What Is a Business Disaster Loss?
A business disaster loss is damage, destruction, or loss of property used in a trade or business due to a “casualty.” For this reason, the terms “disaster loss” and “casualty loss” are often used interchangeably. A casualty is a sudden, unexpected, and unusual event such as a fire, flood, freeze, earthquake, storm, hurricane, tornado, landslide, government-ordered demolition or relocation, or terrorist attack. (IRS Pub. 547, Casualties, Disasters, and Thefts (2019), dated Feb. 19, 2020, p. 3)
Events that would not be classified as “disasters” can also be casualties. For example, a car accident qualifies as a casualty so long as it’s not caused by your willful act or willful negligence. Losses due to thefts and vandalism can also qualify.
Unlike the individual’s loss deduction, the business does not need a presidentially declared disaster to claim a tax deduction for its loss to business property. For tax years 2018-2025, individual taxpayers may deduct a casualty loss only if it’s due to a presidentially declared disaster. (IRC Section 165(h)(5))
Calculating a Business Disaster Loss
The casualty loss deduction permits you to deduct an amount equal to the decline in the property’s value due to a casualty, up to the amount of your investment you have not already deducted through depreciation or otherwise reduced by insurance or other reimbursements.
The amount of a disaster loss depends on the property’s adjusted basis, whether the loss is covered by insurance, and whether the property was totally destroyed or only damaged by the casualty event. You can use IRS Publication 584-B, Business Casualty, Disaster, and Theft Loss Workbook, to calculate your loss.
Adjusted basis. The basic rule for your loss deduction is that you can deduct the amount of the property’s decline in value up to its adjusted basis. You always face adjusted basis as the ceiling for the deduction. (IRC Section 165(b))
Your adjusted basis is usually the property’s original cost; plus the value of any improvements; minus all deductions you took for the property, including depreciation and Section 179 expensing. You determine the basis for a building, land improvements, and landscaping separately. Basis is reduced by the amount of claimed disaster losses and insurance recoveries. Business personal property (computers and other equipment, for example) often have a zero adjusted basis because 100 percent of the cost can be deducted in the year of purchase with 100 percent bonus depreciation (through 2022) or Section 179 expensing. In this event, the disaster loss deduction is zero. But your repair costs may be currently deductible (as explained later in this article).
Example. Sara purchased a computer for $2,000 two years ago for her home business. She deducted the entire cost that year with bonus depreciation. Her adjusted basis in the computer is zero. A fire destroyed the computer. Sara’s disaster loss deduction is zero.
Insurance and other reimbursements. In addition to the adjusted basis ceiling, you must reduce your disaster loss deduction by the amount of any insurance proceeds or other reimbursement you actually receive or reasonably expect to receive. (Reg. Section 1.165-1(d)(2)(i)) Other reimbursements could include a court award of damages based on the event, forgiveness of a federal disaster loan, or payment of repairs by a lessee.
If the reimbursement turns out to be less than you expected, you can claim a loss in the year you determine you’ll receive no further reimbursement. Don’t amend your original return for the prior year. If the reimbursement is larger than expected, you must include the amount in income for the year received to the extent you obtained a tax benefit from the excess loss claimed in the earlier year.
Note: If you’re uncertain about the amount of reimbursement you’ll likely receive. In that case, the IRS advises waiting to deduct the amount about which you’re uncertain until the year you’re reasonably certain about the reimbursement, if any.
Unlike with personal casualty losses, where you have to file the insurance claim if you want a loss deduction, you don’t have to file an insurance claim to qualify for the business disaster loss deduction. In some cases, you could be better off not filing a claim if the claim will result in substantial increases in your insurance premiums or cancellation of your policy.
Property a total loss. If the property is completely destroyed or stolen, your deduction is calculated as follows:
Adjusted Basis – Salvage Value – Insurance Proceeds = Deductible Loss
“Salvage value” is the value of what remains after the property is destroyed. This is often nothing.
Example. Sean, a 1099 worker, suffers a fire that ravages his apartment and destroys his business computer. He paid $2,000 for the computer. Sean has taken no tax deductions for it because he purchased it only two months ago, so his adjusted basis is $2,000. Sean is a renter and has no insurance covering the loss. Sean’s casualty loss is $2,000 ($2,000 Adjusted Basis – $0 Salvage Value – $0 Insurance Proceeds = $2,000).
Partial loss. If the property is only partly destroyed, your casualty loss deduction is the lesser of:
- the decrease in the property’s fair market value immediately after the event, or
- its adjusted basis.
You must reduce both fair market value and adjusted basis by any insurance proceeds you receive or expect to receive.
Example. The chimney in Sally’s rental home collapses during an earthquake. She has no earthquake insurance coverage. She pays $5,000 to a building contractor to restore the chimney to the condition it was in before the earthquake. She figures her casualty loss deduction as follows:
Adjusted basis of the home before the earthquake $96,000
Fair market value before the earthquake $225,000
Fair market value after the earthquake $220,000
Decrease in fair market value (based on cost of repair) $5,000
Amount of loss (lesser of adjusted basis or decrease in value) $5,000
Insurance reimbursement $0
Deductible loss ($5,000)
Determining Decline in Property Fair Market Value
There are two ways to determine how much a disaster reduced your property’s fair market value: (Reg. Sections 1.165-7(b)(2)(i); (ii))
- An appraisal by a qualified appraiser
- The cost of repair
The appraiser should determine the fair market value of the property just before and just after the event. The decline in fair market value does not include any general decline of property values in the area due to the disaster.
You can use the cost of repairing the property instead of an appraisal only if the repairs are actually completed by the due date for your business tax return,
- the repairs are necessary to bring the property back to its condition before the casualty,
- the amount spent for repairs is not excessive,
- the repairs take care of the damage only, and
- the value of the property after the repairs is not greater than before the casualty.
Note: The cost of repairs is not the casualty loss. It is used only as evidence of the decline in the property’s fair market value. If you obtain an appraisal, you don’t have to repair or replace the property to claim a casualty loss deduction.
There are two ways you can deduct a loss of inventory due to a disaster: (See IRS Pub. 547, Casualties, Disasters, and Thefts (2021))
- Treat the loss as part of your cost of goods sold for the year. Don’t claim this loss again as a casualty or theft loss. Include any insurance or other reimbursement you receive for the loss in gross income.
- Deduct the loss as a casualty loss. Eliminate the affected inventory items from the cost of goods sold by making a downward adjustment to opening inventory or purchases. Reduce the loss by any reimbursement you receive. Don’t include the reimbursement in gross income.
When to Deduct Disaster Losses
You may claim a disaster loss in the year it is sustained. But if the loss was caused by a federally declared disaster, you have the option of claiming it for the prior year (IRC Section 165(i)(1); Reg. Section 1.165-11). This can provide a quick refund of tax you paid for the prior year. Federally declared disasters are listed on the Federal Emergency Management Agency (FEMA) website.
You must make an election to claim the loss for the preceding year on IRS Form 4684, and attach it to your amended or original return for that prior year. You figure the loss and the change in taxes as if the loss had occurred in the preceding year. The election must be made within six months after the regular due date for filing your original return for the disaster year. For example, if you’re a calendar-year taxpayer, you have until October 15, 2021, to amend your 2019 return to claim a disaster loss that occurred during 2020.
If you make this election, it applies to the entire loss sustained as a result of the disaster. (Reg. Section 1.165-11(c))
Net Operating Loss
If your casualty loss deduction exceeds your income for the year (before considering the casualty loss), you’ll have a net operating loss (NOL) for the year.
You can carry back for five years an NOL for 2018, 2019, or 2020 and obtain a refund of tax paid for those years. You then carry forward any unused amount indefinitely. NOLs occurring in 2021 and later can be carried forward only, but indefinitely. (IRC Section 172(a)(2))
If the total insurance compensation and other reimbursements you receive are more than the adjusted basis in the destroyed or damaged property, you’ll have a casualty gain, not a loss. This is common with business personal property such as computer equipment that is often fully expensed or depreciated.
Example. Sara purchased a $5,000 computer system for her business two years ago. She deducted the entire cost that year with bonus depreciation, so her adjusted basis in the system is zero. A fire destroys the system, and she receives $4,000 in insurance proceeds. Sara gets no casualty loss deduction since her adjusted basis is zero.
Instead, she has a $4,000 casualty gain. Sara reports her basis, insurance payment, and gain on IRS Form 4684. Because the computer system is Section 1245 property, the rules deem the casualty a sale of the computer that Sara reports on Form 4797, Sale of Business Property. This is reported as ordinary income, not subject to self- employment tax if Sara chooses to recognize the gain.
Under the involuntary conversion rules, Sara can defer the gain by purchasing replacement property of equal or greater value. Her basis in the replacement property is its cost reduced by the amount of unrecognized casualty gain.
Example. Sara purchases a new computer system for $6,000 three months after the fire. Her basis in the new system is $2,000 ($6,000 cost – $4,000 gain).
If the cost of the replacement property is less than the reimbursement received, Sara must recognize the gain to the extent the reimbursement exceeds the cost of the replacement property.
Loss not due to a federal disaster. If the casualty loss is not due to a federal disaster, the replacement property must be “similar or related in service or use to the property destroyed.”
Loss due to a federal disaster. If the property was damaged or destroyed in a federal disaster, you have four years to purchase the replacement property. Additionally, any business-use property will qualify.
Deducting Repairs for Damaged Property
As mentioned above, repair costs are not part of the casualty loss deduction. They are merely used to measure the decline in fair market value due to a casualty.
Can you take a casualty loss and then deduct your repair costs as an ordinary and necessary business expense?
No. The IRS repair regulations provide that the cost of restoring property damaged by a casualty for which a reduction of basis is required must be capitalized (depreciated) and added to the property’s basis.
Example. Jason owns an apartment building with a $500,000 adjusted basis that suffers extensive uninsured damage due to a flood. An appraiser determines that the decline in the building’s fair market value is $50,000, and Jason deducts this amount as a casualty loss. He then hires a contractor and pays her $50,000 to repair the damage to the building. The repair costs must be separately depreciated over 39 years as an improvement and added to the building’s basis.
Reporting a Casualty Loss
If you’re a sole proprietor or an owner of a one-member LLC taxed as a sole proprietorship, complete Section B of Form 4684, Casualties and Thefts. Use a separate Form 4684 for each casualty. Losses are netted against gains and transferred to Form 4797, Sales of Business Property. The net loss or gain is entered on Schedule 1 of Form 1040.
Note for the self-employed. The net loss does not go on Schedule C, and thus does not reduce or increase self- employment taxes.
Multimember LLCs, partnerships, S corporations, and C corporations report casualty loss or gain on Form 4797. The net gain or loss is entered on a specific line on Form 1065 (LLCs and partnerships), Form 1120-S (S corporations), or Form 1120 (C corporations). It thereby reduces or increases the total business income of the entity.
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