Filing Home Casualty Losses a Complex Income Tax Matter

The Northridge earthquake has jolted many homeowners throughout the San Fernando Valley and Ventura County into a crash course in the tax implications of casualty losses and home foreclosures.

Some local residents have learned that their “casualty losses,” or damages to the property, from the earthquake aren’t fully tax-deductible, and that they may also owe the IRS a tax for a “profit” on their home, even if their homes were destroyed and they are walking away from their mortgage.

One key factor in sorting out all this is what the IRS calls the adjusted basis--or real cost--of your residence. The adjusted basis for a home is the purchase price, plus any permanent improvements added during the time you have owned that home. Or when a homeowner moves up in value from one house to another, the tax basis of the second home is equal to the tax basis of the first home, plus any difference between the sales price of the first home and the purchase price of the second home, plus improvements on the second home.

Calculating the adjusted basis correctly is important for two reasons. First, the higher the adjusted basis of your home, the smaller your capital gains tax on the property. Second, you have to know your adjusted basis to figure out your casualty losses, including earthquake damage.

While the IRS does not recognize capital losses in the sale or exchange of a residence, the IRS does recognize casualty losses--including from earthquake damage--as tax-deductible, explained Marvin L. Weisbrod, a vice president at Triple Check Income Tax Service Inc. in Burbank.

Even the math on casualty losses is convoluted. Why? Because the IRS requires homeowners who suffer a casualty loss to report the lesser of the difference between 1. fair market value of the property just before and just after the earthquake, or 2. the adjusted basis of your residence, minus 10% of your adjusted gross income (plus $100).

Weisbrod gives an example of a couple in Northridge who had a home worth $700,000 before the January quake. Because the home was destroyed, the fair market value is now just $300,000. This couple lived in their home for several decades, and so the adjusted basis of their home is a modest $120,000.

The difference between the before and after earthquake value of their home is a whopping $400,000. Still, in this situation for tax purposes, the couple would only be able to write off a total casualty loss of $104,900. Why? Using the other calculation the IRS insists on: This couple has an adjusted gross income of $150,000; by subtracting $15,100 (10% of their adjusted gross income, plus $100), from their $120,000 adjusted basis of their home, they wind up with only $104,900 in casualty losses, Weisbrod said.

This is an example of why it pays to do everything possible to beef up the adjusted basis of the residence.

Property owners who receive money from their earthquake insurance policy, or other compensation from property that was damaged by the quake, ordinarily have a taxable gain if the compensation received exceeds the adjusted basis of the property.

But that tax can be deferred by electing to use the insurance proceeds to restore the property within four years. If the residence cannot be restored, the gain can be deferred by using that gain toward the purchase of another residence. The replacement period for the property involuntarily converted as a result of a presidentially declared disaster--such as the Jan. 17 quake--was extended by Congress in 1993 to a period of four years after the close of the first taxable year in which any part of the “gain” upon conversion is realized.

Homeowners can defer capital gains indefinitely by rolling over their gain on one home into another home of equal or greater value. Owners age 55 and over who sell their homes also have a onetime opportunity to realize up to $125,000 in profit tax-free on the sale of their primary residence.

But there has been no absolute ruling from the IRS that the “capital gain” in a quake foreclosure can be rolled into another residence, pursuant to IRS Section 1034. Not all accountants agree on whether this is a legal option for homeowners who suffered a foreclosure--assuming they have the wherewithal to buy another residence within two years.

Valley residents who suffered a casualty loss, may be able to argue that the foreclosure occurred because of the earthquake and that therefore it is an “involuntary conversion,” which is given more favorable treatment by the IRS in Section 1033, said Tony A. Rose, CEO of Burbank accounting firm Rose, Snyder & Jacobs. Ultimately, he said, this issue of rolling over a “gain” from a foreclosure may depend on getting a more definite answer from the IRS in the form of a ruling.

And there’s more to this tax nightmare. “After the earthquake, there are many homeowners who have lost the records of how much money they have spent to improve their homes. That makes estimating the adjusted tax basis of the residence a problem,” said Robert Jay Grossman, an attorney in private practice in Century City. When homeowners don’t take the time to properly calculate the increase in their adjusted basis due to improvements, Grossman said, “they can be devastated when they get the tax bill.”

The general rule is that “permanent improvements” can be added to your adjusted basis whereas maintenance or replacement can’t be included in that calculation. If, at some point, you replaced your carpets, this probably won’t help you increase the cost basis of your home. But, owners who upgraded from a cheap shag to a pricey wool Berber can probably use the price differential between merely replacing the old carpet versus installing the upgraded floor covering.

Matters become further complicated when a homeowner does a series of renovations over several years. An owner might reface kitchen cabinets one year and then replace the cabinets altogether a few years later. Can the refacing job still count as part of cost basis? The answer depends on whether the old improvements were trashed or whether they were added to.

Accountants and attorneys generally agree on the following: The cost of buying a home does figure into your cost basis. This includes attorneys’ fees, title search and insurance, late closing charges, the cost of cleaning up title, brokers’ commissions, property surveys, appraisal fees and the cost of recording documents. Improvements include installing storm windows and doors, adding a room, finishing a basement or attic, new plumbing or a furnace, a swimming pool or landscaping expenditures. Some of the things generally not considered permanent improvements are repainting a house, mending leaks or fixing gutters.

Before and after photos or videotapes can also help if you’re ever called in for an IRS audit.

More information about the cost basis of your home is available by ordering a free 14-page IRS publication entitled “Tax Information on Selling Your Home.” This booklet, along with IRS form 2119, used to figure the cost basis of the old home and the so-called adjusted basis for any new home purchase, are available by telephoning the IRS toll-free at (800) TAX-FORM.