[Ellen McElroy]
In late October, Hurricane Sandy caused significant damage to many businesses throughout the Northeastern United States. In the past, business taxpayers experiencing similar storm damage would have focused primarily on the loss provisions of Section 165 to address tax concerns. The tax questions that would have been asked following such a casualty would have been limited to whether a loss could be claimed and the amount of any loss deduction.
However, the IRS issued temporary regulations under Section 162 last December that address the treatment of costs associated with tangible property, commonly referred to as the "2011 Regulations" or the "repair regulations," in which a questionable casualty loss provision was included.1 With this change, the government has limited certain repair deductions that taxpayers could otherwise claim if the repairs arise with respect to property for which a casualty loss deduction has been taken. As a result of this position, some taxpayers will feel that they have been hit hard, first by the damaging effects of the storm and then by the limitations in the regulations. Because these rules are implemented with an accounting method change, as discussed below, business taxpayers should carefully consider the effect of both the casualty loss provisions and the repair rules prior to claiming a casualty loss.
By way of background, Section 165 allows a deduction for "any loss sustained during the taxable year" if it is not compensated for by insurance.2 Section 165 is designed to compensate taxpayers for losses. With casualty losses, the deduction is limited to the lesser of either: (i) the reduction in the property’s fair market value as a result of the casualty; or (ii) the adjusted basis of the damaged property.3 For this purpose, fair market value is determined through appraisals and the costs of repairs to damaged property that support evidence of lost value.4 If the property is completely destroyed and the fair market value is less than the property’s adjusted basis, then the loss is limited to the taxpayer’s adjusted basis.5 Of course, any potential casualty loss deduction is also reduced by the amount of insurance proceeds received. Further, if the business property consists of more than one component, for example, if property includes both land and a building, the components are segregated and the basis for each component is separately determined.6
In certain circumstances, the taxpayer may be disadvantaged by the casualty loss rules. For example, if the casualty loss is significant, and it occurs well after the property has been placed in service, the casualty loss deduction may be limited to the property’s adjusted basis amount, which may not approximate the fair market value of the property at the time of the casualty. However, if the loss occurs soon after the property is placed in service, the casualty loss deduction may more closely approximate the amount of the taxpayer’s actual loss. Another complication exists if the property has appreciated while being held by the taxpayer. In that situation, the basis may be significantly less that the property’s fair market value, in which case the casualty loss deduction will be less than the taxpayer’s actual loss. This result is further complicated if repairs are necessary to return the damaged property to its original condition. In many cases, when property is damaged but not completely destroyed, repairs are required to ensure that the property remains operational. Many such repairs are the types of activities that otherwise qualify for a repair expense deductions under Section 162. And that should be the result—but for a new rule announced by the IRS and Treasury.
In late December 2011, temporary and proposed regulations were issued, which address the treatment of costs associated with tangible property. These regulations address, among other things, the treatment of repair expenses.7 Under these rules, many costs associated with repairing property and keeping it in good operating condition are treated as business deductions under Section 162. In fact, but for a single provision, in many circumstances, costs associated with repairing property following a casualty such as Hurricane Sandy would have been characterized as a deductible repair expense.
In particular, the repair regulations provide that taxpayers "must capitalize amounts paid to restore a unit of property" and the repair regulations provide that restoration costs include amounts paid "for the repair of damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under Section 165 or relating to a casualty loss described in section 165."8 This provision is known as the "casualty loss rule."
In essence, the repair regulations adopt a per se rule that any repair to property for which a taxpayer has taken a basis adjustment as a result of casualty loss deduction under Section 165, or relating to a casualty event described in Section 165, is characterized as a restoration and the costs of which are required to be capitalized and recovered over the useful life of the damaged property.9 This rule requires that any cost of repairing property damaged as a result of a casualty where a casualty loss was claimed or the basis was otherwise adjusted (e.g., to reflect the receipt of insurance proceeds). This rule requires capitalization of the costs of repairing even minor damage when any amount of basis, no matter how small, remained in the property subject to the casualty loss. When the taxpayer’s remaining basis is almost fully depreciated, the replacement cost of the repair could far exceed the amount of the allowable loss deduction under Section 165.
Moreover, once capitalized as a result of the casualty loss rule, these amounts are recovered not over the property’s remaining useful life but over the property’s useful life. For example, buildings have a 39-year useful life. Thus, if a building that had been placed in service for 10 years was partially destroyed in Hurricane Sandy and the taxpayer took a casualty loss for such damage and then incurred costs to repair the building to return it to its original condition, these costs, which would otherwise be considered deductible repair expenses, would become non-deductible because of the casualty loss rule. These capital expenditures would be recovered not over 19 years, the remaining useful life of the building, but over 39 years.
The casualty loss rule was added to the repair regulations in response to concerns within the IRS that taxpayers were being unjustly enriched when taking both casualty loss deductions and repair deductions following a casualty. Earlier proposed regulations in both 2006 and 2008 included the faulty casualty loss rule. Although this position was retained in the 2011 regulations, the government revised its articulation of the rationale for the rule in the Preamble to the regulations.10 In response to pressure from taxpayers and practitioners, the Preamble acknowledges that Section 165 loss and the Section 162 repair expenses "do not create a double deduction for the same item;" the Preamble further notes that the purpose of both provisions is distinctive, that Section 165 is designed to compensate taxpayers from losses while Section 162 allows deductions for ordinary and necessary expenses associated with business operations.11 This Preamble discussion would lead to the conclusion that both deductions should be available to taxpayers, and because these are distinctive Code sections, taxpayers should be able to take advantage of both provisions. However, the 2011 regulations nonetheless disallow a deduction for repair expenses under Section 162 if the taxpayer has claimed a Section 165 loss on the same property.12 The Preamble explains that the casualty loss rule in the repair regulations does not eliminate the benefit provided by the casualty loss deductions under Section 165. Instead, the Preamble argues that the casualty loss rule "is consistent with the fundamental principle that a taxpayer must capitalize the cost of acquiring new property"13 and that the rule prevents "the acceleration of deductions for both the casualty loss and the costs of restoring the property."14 Contrary to this explanation, the casualty loss rule places taxpayers taking advantage of casualty loss deductions in a disadvantageous position. As such, it does seem to eliminate a benefit that is otherwise available to taxpayers. Moreover, this result is especially harsh when property is restored following a storm because taxpayers will be prevented from claiming future repair deductions to that property merely because a casualty loss deduction has been previously claimed.
The disposition rules minimize the results of the casualty loss rule somewhat by permitting taxpayers to make a general asset account election.15 Specifically, the temporary regulations include changes to the general asset account provisions of Treas. Reg.§ 1.168(i)-1. As a threshold matter, taxpayers may account for an asset individually in a single-asset account or may group similar assets in general-asset accounts. The general-asset account rules allow taxpayers to group assets of the same asset class, subject to the same applicable depreciation method, recovery period, and convention. When the assets are placed in service, assets in a general-asset account are essentially depreciated as a single asset.
Generally, a loss is not recognized upon the disposition of property from a general asset account.16 The taxpayer instead continues depreciation.17 As revised by the repair regulations, a taxpayer may elect to terminate the general asset account and recover its basis in assets when the taxpayer: (i) disposes of all assets; (ii) disposes of the last asset in the particular general asset account; or (iii) disposes of the asset in a qualifying disposition, which under the repair regulations, has been expanded to cover many dispositions.18 Thus, if assets are maintained in a general asset account, a taxpayer generally may elect not to recognize the loss on a disposition, and may deduct the cost of the repair or replacement, and continue depreciating the basis of the replaced asset.
Without the general asset account election, the 2011 regulations provide that taxpayers must treat the replaced component as having been disposed of.19 Consequently, when a taxpayer restores property damaged in a storm like Hurricane Sandy for which a casualty loss has been taken, a taxpayer must capitalize restoration costs in accordance with Treas. Reg. § 1.263(a)-3T(i)(1(i). If, however, the general-asset account election has been made, a taxpayer is allowed the opportunity to elect to forgo the loss and deduct repair expenses.
As noted above, because these rules are implemented through an accounting method change, treatment of these issues should be carefully considered. It is important to note that the IRS has indicated that it will delay the effective date of the 2011 Regulations.20 As described in Notice 2012-73, the IRS plans to issue guidance amending the earlier regulations so that the rules will apply to tax years beginning on or after Jan. 1, 2014. However, taxpayers may choose to apply the rules to tax years beginning on or after Jan. 1, 2012, as long as supplemental method changes are made when the 2011 Regulations are finalized.
Consequently, taxpayers are left in the unusual position of great flexibility regarding how to address casualty losses arising as a result of Hurricane Sandy. These issues weren’t created by the storm, but the storm highlights the significance of these issues. Certain taxpayers may find it beneficial to adopt the 2011 Regulations early and choose to make a general-asset account election. Others may choose alternative approaches. Tax positions should be taken keeping in mind the IRS’s historic treatment of these issues and anticipated treatment under the final regulations. Because the rules are not yet effective, taxpayers should consider the alternatives and the accounting method considerations. A method change may be required for the 2012 tax return and then regardless of the approach used, it is likely that the treatment will be revised when the 2011 Regulations are finalized and additional accounting method changes will be required at that time.
Endnotes
1 REG-168745-03, 76 Fed. Reg. 81129 – 81131 (Dec. 27, 2011), 2012-14 I.R.B. 718, available at http://www.gpo.gov/fdsys/pkg/FR-2011-12-27/pdf/2011-32246.pdf. This package includes a Notice of Proposed Rulemaking and Temporary Regulations (referred to as the "2011 Regulations" or the "repair regulations").
2 Section 165(a) provides that a loss is allowed for "any loss sustained during the taxable year and not compensated for by insurance or otherwise." Treas. Reg §1.165-7(a)(1) further describes a casualty loss and provides that a deduction is available for "any loss arising from fire, storm,, shipwreck, or other casualty" in the taxable year the loss was sustained.
3 Treas. Reg. § 1.165-7(b)(1). In this regard, the standard is the lesser of: (i) the reduction in fair market value, i.e., a comparison of the fair market value of the property before the casualty as compared with its value immediately after the casualty; or (ii) "the amount of the adjusted basis prescribed in §1.1011-1 for determining the loss from the sale or other disposition of the property involved." Treas. Reg. §1.1011-1 provides that the adjusted basis for determining the gain or loss from the sale or other disposition of property is the cost or other basis prescribed in Sections 1012, 1016, 1017, and 1018. Treas. Reg. § 1.165-7(b)(1)(ii) also provides that if the property is totally destroyed by casualty and if the fair market value of the property immediately before the casualty is less than its adjusted basis, then the adjusted basis is the amount of the loss for purposes of Section 165(s).
4 Treas. Reg. § 1.165-7(a)(2).
5 Treas. Reg. § 1.165-7(b)(1).
6 See Treas. Reg. § 1.165-7(b)(1), Ex. 2.
7 Supra, note 1.
8 Treas. Reg. §1.263(a)-3T(i)(1)(iii) provides an amount is paid to restore a unit of property only if ... "it is for the repair of damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under Section 165, or relating to a casualty event described in Section 165."
9 Section 168(i).
10 Preamble to T.D. 9564, Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property, RIN 1545-BJ93, December 23, 2011.
11 Id.
12 Id.
13 Id.
14 Id.
15 Temp. Treas. Reg.§1.168(i)-8T.
16 Temp. Treas. Reg. § 1.168(i)-1T(e)(2)(i).
17 Temp. Treas. Reg. § 1.168(i)-1T(e)(2)(iii).
18 Temp. Reg. § 1.168(i)-1T(e)(3)(ii).
19 Temp. Treas. Reg.§1.168(i)-8T(d).
20 Notice 2012-73; 2012-51 IRB 1 (November 20, 2012).
