In recent years, many Americans have been the victims of natural disasters. If you’re unfortunate enough to suffer a personal casualty loss, here are the federal income tax implications.
Limited Deductions for Personal Casualty Losses
In theory, the federal income tax rules allow you to claim an itemized deduction for personal casualty losses that aren’t covered by insurance. A casualty loss occurs when the fair market value of an asset is reduced or wiped out by a hurricane, wildfire, windstorm, tornado, flood, fire, earthquake, volcanic eruption, sonic boom, and similar disasters, or by theft or vandalism.
Unfortunately, many disaster victims don’t qualify for personal casualty loss write-offs because of the following two rules:
- For 2018-2025, under the Ta Cuts and Jobs Act (TCJA), you can only deduct personal casualty losses that are due to a federally declared disaster. So, if your basement floods because you accidentally left the upstairs bathtub water running for two days, you get no deduction because the damage isn’t due to a federally declared disaster. Also, some disasters are too localized to be declared federally declared disasters. In that scenario, you’re also denied any deduction.
- Assuming your personal casualty loss is due to a federally declared disaster, you must first reduce it by $100. Then, you must further reduce it by an amount equal to 10% of your adjusted gross income (AGI). AGI is the number at the bottom of page 1 of your Form 1040. It includes all taxable income items and selected deductions such as those for IRA contributions, self-employed retirement plan contributions, Health Savings Account (HSA) contributions, and student loan interest.
Example: You incur a $40,000 personal casualty loss from one of this year’s federally declared disasters. You have an AGI of $150,000 for the year. Your federal income tax write-off will be only $24,900 ($40,000 minus $100 minus $15,000). You get no deduction if you don’t itemize. And, if your personal casualty loss isn’t from a federally declared disaster, you get no deduction.
Key Point: Before the TCJA, there was no requirement that a personal casualty loss had to be in a federally declared disaster area to result in a deduction. After 2025, that unfavorable TCJA requirement is scheduled to go away unless Congress extends it.
Special Deduction Timing Rule
Assume you do have a deductible personal casualty loss from a 2023 federally declared disaster after the two subtractions. What next? Since the loss was caused by a disaster in a federally declared disaster area, a special rule allows you to claim your rightful federal income tax deduction on either:
- Your Form 1040 for the year the casualty event occurred or
- An original or ended return for the year before the casualty event occurred.
In effect, this beneficial rule allows you to claim the deduction in the year when it does you the most tax-saving good.
Beware of Involuntary Conversion Gains
When you have insurance coverage for disaster-related property damage — under a homeowners or renters policy — you might actually have a taxable involuntary conversion gain. That’s because when insurance proceeds exceed the tax basis of the damaged or destroyed property, you have a taxable profit as far as the IRS is concerned. Your tax basis in an asset usually equals the original cost plus the cost of improvements minus any depreciation deductions claimed for the property.
For example, you could have a big involuntary conversion gain if your appreciated vacation home was heavily damaged or destroyed and your insurance coverage proceeds greatly exceeded what you paid for the property when you bought it years ago.
If you have an involuntary conversion gain, you generally must report it as income on your Form 1040 unless you: 1) make a gain deferral election and 2) make sufficient expenditures to replace the damaged or destroyed property with similar property by the applicable deadline.
Thankfully, special beneficial rules apply to principal residence involuntary conversion gains. You can make otherwise taxable gains go away by taking advantage of the special rules.
If you think you might have an involuntary conversion gain, consult with your tax advisor for details about rules that might help you minimize or avoid a tax hit.
The current federal income tax rules for personal casualty losses and involuntary conversion gains are not very favorable and are also somewhat tricky. Your tax advisor can help you get the best tax results from an unfortunate situation.