When it comes to insurance, it can be disappointing to realize that you are not going to receive payment on your claim. In these cases, it’s possible to take a tax deduction for the loss you suffer to your property if you are not compensated by insurance and in some special cases waiting for compensation. This is known as a casualty loss.

Natural Disaster

What is a Casualty Loss?

The government defines a casualty loss as damage to, or destruction of, property due to a sudden event. In order to qualify as an eligible “sudden event,” it must be something that is unusual, identifiable, and unexpected. Some of the events that can qualify you to take a casualty loss include:

• Hurricanes
• Floods
• Storms
• Car accidents
• Earthquakes
• Shipwrecks
• Volcanic eruptions
• Terrorist attack
• Tornadoes
• Vandalism
• Fire

If your claim is denied, and the insurance company doesn’t pay it, you are allowed to deduct a portion of your losses from your income. This can be a way to reduce your tax liability, and recover, to some degree, your losses.

Not everything is considered a casualty loss for tax purposes. Accidental breakage or damage, deterioration over time, damage that comes as a result of willful negligence, arson committed on behalf of the taxpayer, and pet-related accidents are not eligible for this take deduction.

Taking Your Casualty Loss Tax Deduction

You can only claim casualty tax losses if your loss amounts to more than 10% of your adjusted gross income. The IRS requires that insurance reimbursement and an additional $100 are also deducted from the amount you are claiming when taking your casualty loss deduction. You don’t have to worry about the details when claiming the casualty loss, TurboTax will make all of the calculations for you and walk you through the appropriate questions, but here is an example:

Your home is damaged by a tornado. Your home was documented to have a $50,000 reduction in fair market value, but your adjusted cost basis was $20,000. So, now you have to go off the lower amount — $20,000. On top of that, you have tornado insurance that covers $10,000 of the damage. So, what’s left that was unpaid as part of your claim is $10,000. You subtract $100 from that number to end up with $9,900. Now, consider your AGI. If your AGI is $45,000, 10% is $4,500. You can deduct the portion of your loss above the $4,500, so you subtract that number from $9,900. Your total deduction is $5,400.

Special Treatment for Federally Declared Disasters

Generally casualty losses are deductible in the year the casualty occurs, however if you suffer casualty loss due to a federally declared disaster that occurs in an area requiring public or individual assistance, then you can treat the loss as having occurred in the year immediately preceding the tax year in which it happened, and you can deduct the loss on your tax return or amended tax return for the year before.

So for instance, if you were a victim of Hurricane Sandy and you already filed your 2011 tax return, you can amend your 2011 tax return and claim your recent loss earlier since your insurance company may take a while.  You may even receive a bigger tax refund for 2011.

If you are expecting reimbursement for part or all of your loss, you have to subtract the expected reimbursement when figuring your loss, even if you are not expected to receive payment until next year.

Deducting a casualty loss isn’t the same as getting a dollar for dollar reduction in your taxes. However, it does provide you with a way to ease some of the pain related to your situation, and help you offset some of the costs that the insurance company has not paid.

Natural Disaster

If you haven’t already filed your taxes and were a victim of recent severe storms, flooding, or disasters you may have more time to pay taxes and file your tax returns if you were affected and in counties designated as federal disaster areas qualifying for individual assistance.

The extended dates are specified by county and may give you an extension to file your 2011 tax return as late as May 31, 2012 (the postponement applies to the normal April 17 tax deadline for filing 2011 individual income tax returns, making income tax payments, and making 2011 contributions to an IRA if you were an affected taxpayer)

You can consult the FEMA website to see if your area was declared a Federal Disaster Area. That web address is http://www.fema.gov/news/disaster_totals_annual.fema

Who May Be Entitled to Relief

Taxpayers affected by disaster and eligible for relief include:

• Individuals whose principal residence and any business entity whose place of business is located in counties designated as disaster areas.
• Any individual who is a relief worker assisting in a covered disaster area, regardless of whether they are affiliated with recognized government or philanthropic organizations.
• Individuals whose principal residence, and any business entity whose principal place of business is not located in a covered disaster area, but whose records necessary to meet the filing or payment deadline are maintained in a covered disaster area.
• Estates or trust that have tax records necessary to meet filing or payment deadlines in a covered disaster area.
• Any spouse of an affected taxpayer with regard to a joint return of the husband and wife.

Claiming Casualty Loss for Disasters

Whether or not your area was declared a federal disaster, you are entitled to claim casualty losses as an itemized deduction on your tax return.  A casualty loss is officially defined as “the damage, destruction or loss of your property from any sudden, unexpected or unusual event such as a flood, hurricane, tornado, fire, earthquake or even volcanic eruption.”  The loss can be from a natural or man-made disaster.

You’ll claim your loss on Form 4684, which is  filed with your tax return. The first $100 of loss is not deductible, and the remainder of the loss is deductible to the extent that it exceeds 10% of your adjusted gross income. Of course, any losses reimbursed by insurance or covered by federal disaster funds aren’t deductible.  TurboTax walks you through, step by step, and makes all the computations for you.

Though a casualty loss is usually deductible in the year it happened, you have the option of taking the deduction on your prior year’s return so you can reap the benefit quickly.  The deadline for choosing in which tax year to claim the loss is generally the due date of your current-year return.  If you’ve already filed, use TurboTax to amend your return on Form 1040X, writing in red at the top of the return  “Disaster” and the name of your city, county or state that was declared a disaster area.

Other Relief Available

The IRS will also waive the usual fees and expedite requests for copies of previously filed tax returns for affected taxpayers. Taxpayers should put the assigned Disaster Designation in red ink at the top of Form 4506, Request for Copy of Tax Return, or Form 4506-T, Request for Transcript of Tax Return, as appropriate, and submit it to the IRS.

Though a tax deduction doesn’t reimburse your loss dollar for dollar, it does reduce your taxable income, resulting in a lower tax bill or bigger refund.

Recent flooding in many parts of the country, such as Massachusetts, New Jersey, West Virginia, Rhode Island, and Tennessee remind us of that. Taxpayers who experience personal property losses not covered by either insurance or government reimbursement might qualify to claim them as casualty loss deductions.

Today, we’ll discuss casualty loss deductions and how flood victims might use these losses to save on their taxes. Let’s start with what a casualty loss is and isn’t. The IRS defines a casualty as “the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual.” Flooding fits nicely into this definition. On the other side, there are losses which are not deductible. Accidental breakage under normal conditions, would not be deductible, for example. Damage to rugs or furniture from a family pet or other damage that is considered progressive deterioration such as slow damage due to rot or insects, would also not qualify.

Next, you will need to find out how much you can write off. You must first determine your basis in the property damaged. For property you purchased, your cost is your basis, for property received as a gift or through inheritance, the basis may be need to be researched.

After you find out how much you can write off, you then need to report a fair market value. In the case of a theft or total loss, it’s zero, but for items that are simply damaged by flood, fire, or accident, you must determine “the price for which you could sell your property to a willing buyer when neither of you has to sell or buy and both of you know all the relevant facts.” Your loss is the lesser of the decrease in fair market value (FMV) due to the casualty OR your basis.

Here are some specific examples to help illustrate the above point: If you paid $100,000 for your home, it was worth $200,000 prior to the flood and worth $130,000 after, then the loss is $70,000 (decrease in FMV).

For that same house, if the ‘after” fair market value was only $80,000, the loss is $100,000. The decrease in FMV is $120,000. The $100,000 basis is the lesser of the two amounts.

If you paid $6,000 for your car, the fair market value prior to the collision was $5,000 and now it’s worth $2,000, the loss is $3,000 (decrease in FMV.) When you then start to fill out form 4684 you’ll find three reductions. First, any losses are naturally offset by any insurance or other reimbursement. Second, each loss is reduced by $100. This is per event, not per item, so one fire would have just one $100 adjustment as would one theft of multiple items. Last, total losses for the year are reduced by 10% of your adjusted gross income. What then remains flows to a Schedule A form.

All in all, if you carry enough insurance, you are likely to never deal with casualty losses on your taxes. On the other hand, if you are under-insured and the losses are large enough, you might find a bit of relief come tax time.