The U.S. has historically allowed deductions for casualty losses originating from certain federally declared disasters. Initially, deductibility of casualty losses was limited to those sustained in the course of one’s trade or business, stemming from fires, storms, shipwrecks, and similar. The types of disasters evolved over time and are now codified in IRC section 165(i).
On March 13, 2020, President Trump declared the coronavirus pandemic a national emergency, prompting relief afforded by the National Emergencies Act, as well as, the Stafford Disaster Relief and Emergency Assistance Act (“The Stafford Act”). The Stafford Act provides taxpayers with the opportunity to deduct certain disaster losses in years prior to the year in which the loss is incurred. This has the potential to provide additional relief to taxpayers affected by the coronavirus pandemic.
Pursuant to IRC section 165(i), taxpayers may elect to deduct certain losses attributable to a federally declared disaster in the “[…] taxable year immediately preceding the taxable year in which the disaster occurred.” In the past, generally, taxpayers deducting section 165(i) losses had tangible damage corresponding with their losses, i.e., a storm visibly damaging a building’s walls and infrastructure. With respect to coronavirus losses, although they seemingly qualify for section 165(i) relief, it may be difficult ultimately linking them to the coronavirus, because in many cases there is no visible, outward damage. At times coronavirus may not be the only event which led to a taxpayer’s losses, so parsing out which losses qualify will be a nuanced task.
It is also important to note that the potential relief afforded in IRC section 165(i) is in addition to the relief provided by the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”).
Disaster Losses Defined
Generally, deductible disaster losses arise when there is a sale or other disposition of property, for less than its fair market value, during the taxable year in which the federal disaster is declared, and which occurred within the ‘disaster area.’ These losses tend to include: 1) abandonment of leasehold improvements; 2) abandonment of a business transaction; 3) permanent business closure; 4) retiring fixed assets; 5) disposal of inventory that cannot be sold; 6) securities sold for less than their fair market value; and 7) sale or exchange of business property for less than its fair market value.
In the current disaster, to be deductible, the losses must be specifically related to the coronavirus pandemic. This is generally a facts and circumstances test, so it can be somewhat nuanced, and depends on a taxpayer’s specific posture.
Difficulties can arise around determining what is within the ‘disaster area’ for purposes of deducting losses related to intangible property, where the property does not have a physical location. It can also be a challenge to determine whether a loss is specifically attributable to the coronavirus pandemic, and what the ultimate value of the loss is.
The Mechanics of Taking Advantage of Prior-Year Losses
To take advantage of deductible losses related to the coronavirus, taxpayers must elect to do so by filing an original or amended income tax return for the year preceding the loss, within six months of the return’s initial filing deadline, without regard to any extension, for the period in which there was a federally declared disaster.
For example, if there was a federally declared disaster in March 2020, and a taxpayer incurred allowable disaster losses related to the disaster during 2020, but they would like to take advantage of the loss in 2019, the taxpayer would need to file an original or amended return for the 2019 tax period, within six months of the 2020 return’s initial filing deadline. The specific due date is dependent on the taxpayer’s classification, which determines their filing deadlines.
Alternatively, the taxpayer can deduct the losses incurred during 2020, the year in which there was a federally declared disaster, on their 2020 income tax return. The decision whether to elect prior-year relief is dependent on a number of factors, which should be reviewed in detail, along with relevant case law and publications.
Additionally, pursuant to IRS rules and regulations, a taxpayer making an IRC section 165(i) election must “[…] include with the original federal tax return or amended federal tax return, an election statement indicating the taxpayer is making a § 165(i) election.” The election statement must include information about the specific disaster, and the property affected.
Taxpayers have the option to revoke an IRC section 165(i) election with certain time restrictions.
Practicality of Relief Timing
Taxpayers who fit within the purview of IRC section 165(i) stand to benefit by either reducing their income in 2019, or alternatively, generating Net Operating Losses (“NOLs”) in 2019, which then have a possible carryback of five years, potentially providing a benefit dating back to 2014. If not for the regulations in IRC section 165(i), the taxpayer would be required to take the loss on their current year return, i.e., the 2020 return. Because the losses can be considered disaster losses, they can be applied to 2019, when taxpayers likely have more income before the COVID-19 economic downturn.
Please contact your Mazars USA LLP for additional information.