Tax Planning for Texas and Other States: Post-Hurricane Harvey

As a Californian, I normally do not consider tax planning for Texas. Due to the horrors of Hurricane Harvey, I have decided to “stretch” and offer Tax Planning Advice for our American Brothers and Sisters devastated by the widespread destruction caused by Hurricane Harvey including: homes, cars, jewelry, personal property, heirlooms, art and clothing whether in Texas, or other states. In addition, damages to their businesses, as well.

What do you do in the face of catastrophe? Act quickly, be smart and protect yourselves and your family. If you are in Texas or neighboring states that are storm & flood ravaged and worry about survival take comfort in these truths: All things must pass (George Harrison got it right), insurance may pay for much of your losses, what is not covered by insurance may be recouped thru tax refunds or tax free future income. Money can solve many problems but not if you lack a plan or give up hope.

Tax Plan

Simply put use your casualty loss from the Texas storms to save taxes and get tax refunds. With the current federal income tax rate up to 45% (39.6% top tax rate, plus 3.8% Medicare tax, with additional tax due from the phase out of personal exemptions and itemized deductions) every $1 lost can bring in up to 45 cents in tax refunds or tax free income (which when combined with insurance recovery may make the “pain of loss” recede and in time be replaced by new choices).

The federal government has a special rule for storm losses. Under IRC Sec. 165 (a): “Any loss sustained during the taxable year may be deducted if it is not compensated by insurance or otherwise. The losses are limited to losses from “fire, STORM, shipwreck, or other casualty, or from theft”. Taxpayers may receive a trifecta of tax breaks: reimbursement by tax planning for storm related damages, any thefts of property from lawlessness, and non-taxable insurance recovery.

The math is simple: Losses = All Hurricane Harvey storm & related losses. Getting back to “even” may include insurance recovery, tax refunds or tax-free income. If not “able to get back to 100% even”, then every $1 recouped is a “win”.

How to Proceed

First, make up a list of all losses. If you have no receipts to confirm purchase do a timeline of the dates purchased (oldest one on top) with description of the property, amount paid (to the best of your recollection) and put this information in a sworn affidavit or a declaration under penalty of perjury.

Second, attach this article to your affidavit or declaration as a legal basis to take these tax losses, which you were first made aware of by this article. Third, request your CPA to prepare IRS Form 4864, attach it to Form 1040 (2017) and file any time after January 1, 2018 declaring the amount of the loss (with any records, appraisals or other evidence of value attached to the Affidavit or Declaration in support).

A Special Tax rule applies for disaster area losses (e.g. Texas). A taxpayer that sustains a loss occurring in a disaster area and attributable to a federally declared disaster can either (1) deduct the loss on the tax return for the year in which the loss occurred or (2) elect to deduct the loss on the return for the preceding tax year (IRC 165(i); Treas. Reg. Sec. 1.165-11.

The election to deduct a disaster area loss in the tax year prior to the loss year is made by filing a return, an amended return, or a refund claim and the election applies to the entire loss sustained by the taxpayer in the disaster area during the disaster period.

The IRS has a special rule for personal residences, which is treated as a disaster loss if the personal residence is rendered unsafe by a disaster in an area determined by the President (US) to warrant federal government assistance. The taxpayer must have been ordered by the state or local government within 120 days after the area is declared a disaster area to demolish or relocate the residence (IRC 165(k). The amount of the deduction is reduced for state partial payments made for disaster aid.

A casualty loss is an ordinary loss and offsets ordinary income, including wages and investment earnings. If your loss is $1m and the federal income tax rate is the maximum 45%, you are entitled to a tax refund of $450,000 (subject to tax audit so be complete and thorough in your loss calculation and include all available records which support the claim).

Under IRC 165(c)(3) an individual may deduct a loss from non-business property (e.g. home, car, furniture) only if it arises from “fire, storm, shipwreck, or other casualty or from theft”. The deduction for a personal casualty loss is limited to the amount that the loss from each casualty (or theft) is in excess of $100 (IRC 165(h)(1); Treas. Reg. Sec. 1.165-7(b)(4). The $100 floor applies only once against the sum of the allowable losses (the aggregate of all items lost).

Under IRC 165(h)(2) if a taxpayer’s personal casualty loss exceed their income, the excess may be deductible only to the extent it exceeds 10% of their adjusted gross income (AGI) for the year.  The $100 floor and 10% of the AGI limit do not apply to a business or income-producing property. The amount of a casualty loss which may be deducted for income-producing property, business property or non-business property is the lesser of:

1. The Fair Market Value of the property immediately before the casualty reduced by its FMV immediately after the casualty, or

2. The Adjusted Basis of the property immediately before the casualty (Treas. Reg. Sec. 1.165-7(b).

If business or income-producing property is totally destroyed, the casualty loss is the adjusted basis of the property if the property FMV immediately before the casualty is less than its adjusted basis.

A Casualty Loss is generally deductible only for the tax year in which the loss is sustained (Treas. Reg. Sec. 1.165-7(a)(1). If the damages cannot be reasonably ascertained in the year of occurrence, the deduction can be taken in later year when the extent of the damage is known. If the loss is in a federally declared disaster area the loss a special election allows the loss to be deducted in the immediately preceding tax year.

Insurance and Casualty Losses are linked. A Casualty loss is reduced by any insurance or other compensation received by the taxpayer. The loss is also reduced by any salvage value. An individual cannot claim a personal casualty loss to the extent the loss is covered by insurance unless a timely insurance claim is filed with respect to the loss (IRC 165(h)(4)(E).

A Casualty Loss can generate a Net Operating Loss, which for the tax year is the excess of allowable deductions over gross income (IRC 172(c); Treas. Reg. 1.172-1).

If the Casualty Losses from Hurricane Harvey exceed gross income the taxpayer will have a Net Operating Loss. An NOL from a trade or business may be claimed as a deduction to the current tax year equal to the aggregate amount of NOLs carried back or carried forward from other tax years (IRC 172(a); Treas. Reg. 1.172-1)

An NOL deduction may not exceed the amount of taxable income for the year of the deduction. An NOL arises in any tax year when the taxpayer’s deductible expenses for the year exceed its gross income.

Generally, a Net Operating Loss must be carried back to the two years preceding the loss year and then carried forward 20 years following the loss year. A special rule applies for casualty losses and disasters, which allows for a 3-year carryback period for an NOL arising from a casualty (e.g. Storm).

The IRS offers excellent guidance in Pub 584, 584B for individuals and businesses.

For now, the rules for Texans and other Americans ravaged by Hurricane Harvey are as follows:

1. Prepare your lists/schedules of lost property and amounts lost.

2. Submit insurance claims.

3. Work with your CPA to prepare the Form 4864 to confirm your losses and provide necessary Affidavits, Declarations and other Supporting Documentation in either your possession or from third parties.

4. File the Form 4864 with your Form 1040 for either tax year 2017 (in Jan 2018 or later) or if appropriate as a Federal Disaster Area file the claim for tax year 2016.

The key decisions are whether to carryback losses for 3 years and seek tax refunds as required (which is only viable if taxes were paid those tax years), and carrying the losses forward for 20 years eliminating tax due on income up to the amount of losses. For wage earners, review reduced federal income tax withholding for carry forward years. For investors and business owners reduce estimate tax payments based on tax projections from your tax advisors.

Most importantly remember America, our great country was fought for and earned by heroic men and women who built the freest, wealthiest most prosperous democracy in history. You are part of a great country whose values of life, liberty and the pursuit of happiness should be your bulwark in dark times. Get on with your life, celebrate your freedom (which is unlike many other countries), get back on your feet and pursue your happiness.

Lastly, since Texans are huge football fans, I leave you with words of wisdom from the great coach, Vince Lombardi, “It is not whether you get knocked down but whether you get back up”. Words to live by.

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