Tax relief may be available for federally declared disasters

In detail

Definition of federally declared disaster area

A federally declared disaster area is an area determined by the President to warrant assistance by the federal government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act. A ‘federally declared disaster’ includes both a major disaster declared under Section 401 of the Stafford Act and an emergency declared under Section 501 of the Stafford Act.

Federally declared disasters most commonly are natural disasters such as hurricanes and tornadoes. Notwithstanding, during 2020, the 50 states, the District of Columbia, and US territories all were declared federal disaster areas as a result of the COVID-19 pandemic. For a discussion of how provisions discussed in this Insight may apply to the pandemic, see the Insight Taxpayers may elect to claim disaster losses in preceding tax year.

Areas that have been declared disaster areas and receive tax relief are identified on the irs.gov disaster relief page.

Disaster loss deduction

Section 165 allows a deduction for a loss sustained during the tax year that is not compensated for by insurance or otherwise. In general, a taxpayer may recognize a loss only if the property is completely worthless. For a casualty loss resulting from an identifiable event of a sudden, unexpected, or unusual nature, however, a taxpayer may deduct a loss for partial destruction or the reduction in value of the damaged property. The loss generally is measured by comparing the value immediately before the casualty with the value immediately after the casualty, but is limited to adjusted basis.

Generally, personal casualty losses of individuals are subject to certain limitations. The 2017 tax reform act disallows personal casualty loss deductions for individuals for losses incurred in tax years beginning after 2017 and before 2026, except (1) to the extent the taxpayer has personal casualty gains or (2) if the loss is attributable to a federally declared disaster.

An individual or business taxpayer in a federally declared disaster area also may elect to deduct a loss attributable to the disaster in the tax year immediately preceding the tax year the loss is sustained (the ‘preceding year’ and the ‘disaster year’, respectively). For example, a calendar-year taxpayer in states that have been declared federal disaster areas as a result of Hurricane Ian may claim a disaster loss sustained from that storm on the taxpayer’s 2021 federal income tax return (return), although the loss occurred in 2022. A loss for which a taxpayer makes the election is treated for all federal income tax purposes as occurring in the preceding year (the tax year the taxpayer claims the deduction).

Regulations under Section 165 provide that a taxpayer must make the election on an original or amended return for the preceding year in the manner specified by other guidance. Thus, for example, Rev. Proc. 2016-53 provides that a taxpayer makes or revokes the election by attaching a statement to an original or amended return providing certain specified information. Taxpayers may submit the required statement by completing Section D of IRS Form 4684, Casualties and Thefts.

A taxpayer must make the election no later than six months after the unextended due date for filing the taxpayer’s return for the disaster year. A taxpayer may revoke an election within 90 days after the due date for making the election. A taxpayer revokes the election by filing an amended return for the preceding year on or before the date the taxpayer files its return (or amended return) for the disaster year and claims the loss. A taxpayer that claims the loss on its return for the disaster year and wishes to make the election to claim the loss in the preceding year must file an amended return for the disaster year on or before the date the taxpayer files an amended return making the election for the preceding year.

Example 1. In 2021, individual taxpayer J sustains a disaster loss in a federally declared disaster area. J makes the election to claim the loss in 2020 by filing an amended return for the 2020 tax year on August 15, 2022, which is within the six months following J’s unextended filing due date for filing her 2021 return. J files her 2021 return on September 15, 2022.

Example 2. J decides to revoke her election to claim the loss in 2020 and to claim the loss on her 2021 return instead. J may file an amended return for 2020 revoking the election and an amended return for 2021 claiming the loss. J must file the 2020 amended return revoking the election by January 15, 2023 (within 90 days after October 17, 2022), and on or before the date J files a 2021 amended return claiming the loss.

Example 3. In 2021, individual taxpayer K sustains a disaster loss in a federally declared disaster area. K claims the loss on his 2021 return filed on April 15, 2022. K then decides to elect to claim the loss on his 2020 return. K may make the election on or before October 17, 2022, by filing a 2020 amended return claiming the loss deduction. K must file a 2021 amended return omitting the loss deduction on or before the date of filing the 2020 amended return.

Involuntary conversions

When property is involuntarily converted into money (e.g., insurance proceeds) as a result of its complete or partial destruction, a taxpayer may elect to recognize gain only to the extent the amount realized on the conversion exceeds the cost of purchasing property ‘similar or related in service or use’ to the damaged property (replacement property). The taxpayer must purchase the replacement property within two years after the close of the first tax year the taxpayer realizes any part of the gain.

Special rules apply to property damaged by federally declared disasters. Tangible property a taxpayer holds for productive use in a trade or business is treated as property similar or related in service or use to involuntarily converted property that was held for productive use in a trade or business or investment and located in a federally declared disaster area. The IRS applied this rule in a 2011 technical advice memorandum (TAM 201111004) to allow a taxpayer to replace inventory destroyed in a federally declared disaster with real property held for productive use in the trade or business.

Observation:  Taxpayers that recently recognized gain as a result of an involuntary conversion of property in a federally declared disaster but did not elect to defer the gain may wish to consider filing a claim for credit or refund.

Enhanced deduction for charitable contributions of inventory

Many businesses assist disaster victims by donating inventory such as food, clothing, toiletries, and medical supplies to charities. Section 170(e)(3) provides a special enhanced deduction for inventory a C corporation contributes to a qualified tax-exempt charity that uses the inventory solely to care for the ill, infants, or needy (e.g., disaster victims) in a manner related to the recipient organization’s charitable purpose. The charity may not transfer the inventory in exchange for money, other property, or services; the taxpayer must obtain a written statement from the charity that includes certain required representations; and any inventory subject to regulation under the federal Food, Drug, and Cosmetics Act must fully satisfy the applicable requirements of that act and related regulations for 180 days before the date of transfer.

In general, the amount of a charitable contribution of property is the fair market value (FMV) of the property, subject to certain reductions. For ordinary income property (e.g., inventory), the reduction generally is the difference between the FMV and the basis of the property. Therefore, the charitable contribution deduction is equal to the basis of the inventory. However, the amount of the enhanced deduction for qualified contributions of inventory equals the lower of (1) FMV of the inventory less 50% of the difference between the FMV and the basis of the inventory or (2) twice the basis of the inventory. Thus, C corporations making qualified donations of inventory to charities that will use the inventory to care for disaster victims may take a charitable contribution deduction equal to the basis of the inventory plus 50% of the gain, limited to twice the basis of the inventory.

Note:  In general, the total charitable contribution deduction for a C corporation is limited to 10% of the corporation’s taxable income (as defined under Section 170 for purposes of charitable contributions).

Trades or businesses that are not C corporations (e.g., S corporations, partnerships, or sole proprietors) may claim the enhanced deduction for charitable contributions of only food inventory. Thus, farmers, retail grocers, and restaurants that do not do business as C corporations have an opportunity to claim the enhanced deduction for qualified charitable contributions of food inventory.

The total deduction for charitable contributions of food inventory generally is limited to 15% of taxable income for C corporations and, for taxpayers that are not C corporations, to 15% of the taxpayer’s aggregate net income for the tax year from all trades or businesses from which the contributions are made. However, the annual deduction limitation for contributions of food inventory by a business in 2020 and 2021 is increased from 15% to 25% of taxable income or aggregate net income.