September is National Preparedness Month and the theme this year from Ready.gov is prepare for disasters to create a lasting legacy for you and your family. Said another way with respect to your business…prepare so your business lasts. Recent massive fires and flooding acutely demonstrate the need to prepare, and 6 ideas for preparedness were covered in a previous blog. Hopefully, as part of preparedness you have sufficient insurance to cover your losses. But the reality is that many small businesses don’t have enough coverage and will sustain financial losses as a result of a casualty event or disaster.
Here’s what this means taxwise.
Casualties versus disasters
For tax purposes, a casualty loss results from the damage, destruction, or loss of your property from any sudden, unexpected, or unusual event such as a flood, hurricane, tornado, fire, earthquake, or volcanic eruption. A casualty doesn’t include normal wear and tear or progressive deterioration.
In contrast, a disaster loss is a casualty or other event that receives FEMA designation. The IRS has a list of such designations. Businesses located within such a major disaster area are subject to special tax rules (below).
Here’s how to distinguish between a casualty and a disaster. If your building caught fire due to faulty wiring, that’s a casualty. But if your building burnt down in the Colorado wildfires that took place starting on December 30, 2021, that’s a disaster.
Figuring your casualty loss
Your loss for tax purposes is the amount of your adjusted basis in the property destroyed, which is typically what you paid minus any depreciation. If, for example, you claimed 100% bonus depreciation when you bought a machine for your business in 2020 and it’s totally lost in a fire in 2022, you don’t have any tax loss because your basis is zero; you already wrote off the cost of the machine.
Any tax loss must be reduced by insurance proceeds received. You can’t create a tax loss by failing to submit an insurance claim if you have coverage; your loss will be disallowed if you do. This is so even if you fear your premiums will be increased.
Impact on inventory
If your inventory is gone because of a casualty and insurance doesn’t cover your loss, you have two ways to handle the loss for tax purposes:
- Increase the cost of goods sold by properly reporting your opening and closing inventories. You don’t take a separate casualty loss deduction if you use this option. OR
- Deduct the casualty loss and then eliminate the affected inventory from the cost of goods sold (make a downward adjustment to opening inventory or purchases).
Getting a tax refund
If you have a loss in a federally-declared disaster area, you have the option of claiming it on your return for the year prior to the disaster event. For example, those who were victims of Arizona severe storms between July 17 and July 18, 2022, can claim a disaster loss on a 2021 return. This can be done on an original return if the prior year’s return has not yet been filed or on an amended return if it has been filed. Watch for time limits for electing to claim the loss on a prior year return…or changing your election.
Did you know you can have a gain as a result of a casualty? This occurs when insurance proceeds you receive are greater than the adjusted basis of the property destroyed or damaged. You can, however, avoid immediate tax on the gain by reinvesting the proceeds in certain replacement property. Find more information about gain situations—involuntary conversions in tax parlance—in IRS Publication 547.
Bottom line…prepare for the worst, but don’t ignore tax rules if the worst happens nonetheless.