Earthquake Deductions Have Limits

Q: My home was severely damaged in the recent earthquake and I do not carry earthquake insurance. Friends are talking about something called an “involuntary conversion” and say I may be able to claim a tax deduction for my losses. Can you explain all this? --C.C.K.

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A: Casualty losses, even on a personal residence, are tax deductible up to the amount of your tax basis in the house minus both $100 and 10% of your adjusted gross income. Be very clear about these regulations. Your deductible loss is limited to either your adjusted tax basis or your actual loss, whichever is lower, not your home’s assessed or market value which could be substantially higher than your tax basis depending on when you purchased the home and whether you rolled over untaxed profits from a previous home.

Here’s how it works: Let’s say, using very round numbers, that your tax basis in your home is $100,000 and your adjusted gross income is $100,000. Under the Internal Revenue Service guidelines, you would be limited to a maximum casualty tax deduction of $89,900. Here’s how you would figure it: $100,000 tax basis, minus $100, minus $10,000 (10% of your adjusted gross income). It doesn’t matter whether your house is worth $250,000 and will need $150,000 worth of repairs to be habitable again. Your deductible losses are limited as described in the above calcualtion. However, any money you spend beyond the amount of your deduction increases your tax basis in the house and will reduce your potential taxable gain when you sell it.

In addition, once an area has been officially designated a federal disaster area, you have the option of claiming your casualty loss on the current year’s tax return or the previous year’s tax return.

This choice allows you to get a tax refund from the prior year’s tax return processed immediately, giving you some much needed cash. It also allows you to pick the year in which your income was lower, making you eligible for the largest possible casualty loss deduction. For example, if your adjusted gross income last year was $80,000, you would reduce your casualty deduction by $8,000 plus $100, giving you a potential maximum of $91,900. ($100,000, minus $100, minus $8,000.)

But, be careful, a casualty loss claim can trigger a tax audit. So keep receipts, photographs and other appropriate documentation to substantiate your claim. When your loss exceeds your income for the year in which you claim it, you may carry forward to the next year, or back up to three years, the remaining unrecognized loss. But the total of your deductions is still limited to the amount of your tax basis in the home.

An involuntary conversion is an entirely different matter and concerns only taxpayers who receive an insurance settlement or some other sort of compensation for their property losses. IRS rules governing these procedures allow taxpayers up to two years to use the proceeds from their compensation to replace their lost property. The clock on the two-year limit begins running after the close of the tax year in which the involuntary conversion occurred. For taxpayers affected by the earthquake, for example, the replacement clock begins ticking Jan. 1, 1995 and expires Dec. 31, 1997.

Interest From Family Goes on Schedule B

Q: How do I report the interest I receive from a loan I made a family member for a down payment on a home?

B.S.

A: You should include it with any other interest income you receive on Schedule B, Part 1 on your tax return.

Calendar Year Key to IRA Withdrawals

Q: As of which date do I calculate the value of my individual retirement accounts in determining my annual mandatory withdrawal? Also, how do I determine what my age is when I make the withdrawal? Do I use my actual age at the time of the withdrawal or my age as of the end of the calendar year? --G.J.N.

A: The amount of your mandatory distribution should be based on the value of your IRA accounts as of Jan. 1 of the year in which the withdrawal is to be made. You should use your age as of Dec. 31, of the year in which you make the withdrawal, not your age on the actual date the money is distributed.

Inherited Bond Interest Probably Subject to Tax

Q: When my sister died, I inherited some U.S. Savings Bonds on which interest accumulated untaxed. If I cash them in now, what is my tax liability? Is it the amount of interest the bonds have generated from the time I inherit them until I cash them in, or the interest generated from the date of their purchase? --D.J.M.

A: If no taxes have ever been paid on the accumulated interest, then you are liable for taxes on all the interest the bonds have generated. Be careful, however, to check whether your sister’s estate reported that interest on her final income tax return. In some cases, it can make sense for an estate to report accumulated and unrecognized interest on the decedent’s final return.

Why? When the decedent has little or no income for the year in which he or she dies, income--up to certain limits, of course--can be reported and still not be subject to taxes because it doesn’t meet the tax threshold. Perhaps this happened in your sister’s case; you should at least check.

If it did, then your would only be liable for taxes on the interest the bonds have generated since you have held them.

If your sister’s final tax return did not include the bond interest, you are liable for taxes on the whole amount.

However, for the future you should remember to use a decedent’s final tax return to its fullest advantage.