Lesson From The Tax Court: Gotta Get Physical For Casualty Loss Deduction

Individuals generally cannot deduct casualty losses, at least through the end of 2025.  §165(h)(5). But Congress continues to permit individual taxpayers to deduct casualty losses if they are attributable to a federally declared disaster. Id. 

And we are having more and more disasters.  Call it climate change, call it a banana, the brutal fact is that “the number of natural disasters per year has increased significantly in recent years.” That quote is from this June 2023 Forbes Advisor article, which goes in to great detail explaining that conclusion.  And there has been a corresponding increase in FEMA disaster declarations over time as well.  See Congressional Research Services “Stafford Act Declarations 1953-2016: Trends, Analyses, and Implications for Congress,” (Aug. 28, 2017). 

So today’s lesson is still useful even if Congress never restores the general casualty loss deduction.  In Thomas K. Richey and Maureen P. Cleary v. Commissioner, T.C. Memo. 2023-43 (Mar. 28, 2023) (Judge Holmes), we learn the basic, but vital, lesson that that a taxpayer must prove that some identifiable event caused actual physical damage to their property.  Just because there is a storm and you then spend money on your property does not prove the storm caused damage to your property.  In today’s case the taxpayers reported casualty losses of some $820,000 for damages to their vacation home and boat.  But they were unable to prove the claimed losses arose from a casualty event.  Details below the fold.

Law:  The Basics of Casualty Loss Deductions for Individuals
Section 165(c) permits individual taxpayers a deduction for losses resulting from “fire, storm, shipwreck, or other casualty, or from theft.”  Section 165(h)(5) says that after 2017 and until 2026 the casualty must also qualify as a federally declared disaster, which basically means you need a disaster declaration from FEMA.

To get the deduction, a taxpayer must first show they are entitled to it and then must prove amount.  There are different rules for casualty losses to property used in a trade or business, but that’s for a different lesson.  This is just a short summary of the deduction rules for personal casualty losses incurred by individuals.

(1) Entitlement.  The taxpayer must prove there was a casualty event.  A casualty event is one that is sudden and unexpected.  Storms fit the definition easily.  Termite infestations do not; even if your discovery of termites is sudden and unexpected, why they have been around a while, munching away.  Dodge v. Commissioner, 25 T.C. 1022 (1956).

The event must also cause actual physical damage.  The classic example is Pulvers v. Commissioner, 407 F.2d 838 (9th Cir. 1969).  There, a mudslide wiped away three nearby homes but did not physically damage the taxpayer’s home.  The taxpayers tried to take a casualty loss for the resulting decrease in fair market value.  The courts said “no.”

(2) Amount.  Once a taxpayer establishes entitlement, they must then prove the proper amount of the deduction.  I teach students to think of §165 as a capital recovery provision.  It protects taxpayers from losing that which they have put into property, but no more.  Thus the upper limit of the deduction is the taxpayer’s basis in the property.  Section 165(b) tells us that “the basis for determining the amount of the deduction for any loss shall be the adjusted basis provided in section 1011 for determining the loss from the sale or other disposition of property.”

But the amount of loss might be less than basis.  Treas. Reg. 1.165-7(b)(1) says the permitted deduction is the lesser of basis or loss of fair market value.  And that is what confuses a lot of folks because figuring out the loss of fair market value can be tricky.  The regulations give some good guidance on how to do that.

First, Treas.Reg. 1.165-7(a)(2)(i) says the taxpayer can prove loss of fair market value by a “competent appraisal” but then warns that such appraisal “must recognize the effects of any general market decline affecting undamaged as well as damaged property which may occur simultaneously with the casualty, in order that any deduction under this section shall be limited to the actual loss resulting from damage to the property.”

Second, Treas. Reg. 1.165-7(a)(2)(ii) permits taxpayers to use their cost of repairing actual physical damage as the measure of their fair market value loss.  Still, the burden is on the taxpayer to show “that (a) the repairs are necessary to restore the property to its condition immediately before the casualty, (b) the amount spent for such repairs is not excessive, (c) the repairs do not care for more than the damage suffered, and (d) the value of the property after the repairs does not as a result of the repairs exceed the value of the property immediately before the casualty.”  In other words, while taxpayers can certainly use storm damage as an excuse to make improvements to their property, they cannot take a deduction for the costs of improvements, only for the cost of repairs and only because of the presumption that those repair costs represent the loss of fair market value.

Third, even once the taxpayer establishes the correct amount of loss (whether basis or change in fair market value), calculating the allowed deduction requires reducing that amount by a series of rules:  (a) it must be reduced by any compensation for the loss either actually received “by insurance or otherwise” §165(a).  If the taxpayer has insurance and fails to make a claim, then §165(h)(4)(E) denies the deduction completely; (b) individuals must reduce the amount by $100.  §165(h)(1); and (c) while individuals can then offset any casualty gains by their losses, if they end up with net casualty losses, they may only deduct those to the extent the losses exceed 10% of their adjusted gross income.  §165(h)(2).

There.  I think that’s all the relevant basic rules!

What confuses taxpayers is that regardless of how they try to establish a loss of fair market value, they must still link that to actual physical damages.  As the Tax Court has said many times: “The Code contemplates only a loss of capital, or, in other words, actual loss of tangible or measurable property. This does not encompass a failure of profits or the loss of potential income.” Squirt Company v. Commissioner, 51 T.C. 543 at 548 (1969), aff’d, 423 F.2d 710 (1970).  In that case an ice storm damaged the taxpayer’s orchard.  The IRS allowed a deduction for the $9,000 cost of clearing the land after the storm.  The taxpayer sought an addition $45,000 deduction for the loss of fair market value.  The Court denied that deduction, explaining:

The additional decrease in value of $45,000 represents a decline not due to actual physical damage to the land but rather because of the decline in demand for citrus land in the area of Texas. The decline in demand that caused the decrease in market value may have been the result, in part, of the freeze. However, this reduction in market value is not a loss of the character deductible under the casualty loss provisions of section 165.”

The only glimmer of an exception to this is when the decrease in fair market value caused by the casualty event is “permanent.”  For example, in Finkbohner v. United States, 788 F.2d 723 (11th Cir. 1986), a flood wiped out the taxpayer’s neighborhood to the extent that 7 other homes were eventually razed, with the land acquired by the local government to be permanently undeveloped.  A split panel of the 11th Circuit held that the resulting loss of fair market value was not merely a temporary fluctuation but was a permanent change in fair market value caused by the flooding.  The dissent pointed out that the removal of the other homes was based on the fact that the area had been know as prone to flooding, and the particular flood had not permanently altered the character of the land.

I say this is a glimmer.  I would not count on courts—and certainly not the Tax Court—to follow Finkbohner opinion anytime soon.  Last I looked, the case has only been cited eight times since 1986 and, after reading those eight cases, it seems to me that courts give only limited weight to the opinion.  Still....it’s out there and may be useful to readers to at least make an argument.

It was certainly no help to the taxpayers in today’s case.  Let’s take a look.

Facts
The tax year at issue is 2017.  Our taxpayers owned a vacation home in Stone Harbor, N.J., on Cape May, where they also kept a boat.  It appears they had bought the home for some $2.25 million. Nice home.  It appears they had bought the boat for some $480,000.  Nice boat.

In March 2017, Winter Storm Stella hit the upper Northeastern part of the U.S.  It was a pretty bad snowstorm with heavy precipitation and high winds.  Interestingly FEMA issued a disaster declaration only for certain counties in New York.  But nothing for Cape May, or any part of N.J.  Fortunately for Mr. Richey and Ms. Cleary, §165 did not require that the casualty loss be attributable to a federally declared disaster.  If this had happened in 2018 then we might well have a different lesson.  After all, there are intricate politics for how and when FMEA actually declares a disaster.  For a good discussion see Carolyn Kousky, Karina French, Carlos Martín, Manann Donoghoe, “The US needs a new system for declaring natural disasters and distributing federal aid,” Brookings Research Paper (July 14, 2023).

At any rate, Mr. Richey and Ms. Cleary claimed a casualty loss deduction of $640,000 for their home and $180,000 for their boat.  That pretty much enabled them to pay no tax on their AGI of some $850,000 for the year.  Op. at 6.

On audit, the IRS denied the deductions and issued an NOD.  The taxpayers petitioned Tax Court to contest the asserted deficiency.  They lost, giving us our lessons.

Lesson:  No Casualty Loss Deduction Without Proof of Entitlement
The taxpayers’ basic problem was they could not prove that Winter Storm Stella damaged their home or boat.  While Mr. Richey testified to that effect, Judge Holmes did not find his testimony credible.  For example, Mr. Richey testified that “no one would buy their home after the storm without considering the cost of a total rebuild of ‘the retaining walls (from the sea), dock system, and foundation of the home, which suffered significant erosion.’”  Op. at 10, quoting Mr. Richey.  But, as Judge Holmes notes, Mr. Richey “never provided evidence that the damage to the retaining wall or the home’s foundation was storm damage rather than damage from erosion and ordinary wear and tear.” Id.

You would think that it should not be hard to show a storm damaged your property, especially with cell phones able to take 1,000’s of pictures that are then sent to various cloud storage services.  Mr. Richey said he had taken pictures but a later software update to his phone deleted them.  Un huh.  With all the cloud backup services available that’s a pretty lame story.

So all Mr. Richey could do is show the Court some 2018 pictures of the home that showed construction activity on it!  As Judge Holmes notes, the “photographs depict no visible damage other than that which one might see at any construction site, and we could see nothing that showed damage that we could specifically attribute to the storm. They are insufficient to prove that the property was damaged let alone that the damage was attributable to Stella.”  Op. at 7.

As for the boat, the taxpayers showed the Court a picture of the boat before the storm, but showed the Court no pictures of the boat after the storm.  Id.  Nor did they even give the court any receipts for boat repairs.  Gosh, that makes it really hard to claim your boat was damaged, let alone damaged by one particular storm.

The failure of proof here is startling, especially since Mr. Richey was represented by counsel.  I mean certainly the lawyer would know that that the burden is on the taxpayer to prove their entitlement.  Mr. Richey could have brought in witnesses, such as construction workers or the contractors he hired to repair his home, or even neighbors who might testify that “Yep, that storm hit the Richey place pretty hard.”  But he did none of that.  All he had was his sole testimony and some 2018 pictures.  Assuming competent counsel, this leads to a strong inference that Mr. Richey and Ms. Cleary simply had no proof.

Bottom Line: If you are going to claim a casualty loss, you need to document the entitlement.  Don’t just assume that batting your baby blues will do the job!  Here, I think the song “Jeff Sums It Up” from the current musical version of Tootsie best captures the situation these taxpayers found themselves in.

Coda: Judge Holmes is a careful judge.  His holding that the taxpayers here failed to prove their entitlement is a finding of fact and will be reviewed only for clear error.  However, Judge Holmes nonetheless goes on to give a lengthy and very useful explanation of how the taxpayers here also failed to substantiate the amount of damages.  Remember, §165 is a capital recovery provision so the deduction is limited to the lesser of basis or loss of fair market value.  Here, the taxpayers were unable to establish loss of fair market value.  They tried a couple of different approaches and Judge Holmes patiently explains why each is an epic fail. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.

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