Taxpayers who claim a casualty loss due to Hurricane Sandy (or other casualty event) could suffer a harsh penalty under the so-called casualty loss rule in Temporary Treasury Regulation § 1.263(a)-3T(i)(1)(iii). That provision provides that a taxpayer must capitalize amounts paid to restore property, including 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 event described in section 165.” The casualty loss rule applies even if the taxpayer’s casualty loss is ameliorated by insurance.
The potentially dramatic ramifications of this penalty are illustrated by the following example. Assume a taxpayer has property damaged by Hurricane Sandy that had a 15-year recovery period and was placed in service 10 years ago. The cost to repair the property and its remaining basis are both $1 million.
Under the casualty loss rule quoted above, if the taxpayer claims a $1 million casualty loss under section 165, the taxpayer must capitalize the $1 million cost of the repair and recover it over a 15-year recovery period. If the taxpayer does not claim a casualty loss, however, the taxpayer presumably could deduct the $1 million cost of the repair and continue to depreciate the $1 million of remaining basis over the remaining five years of the recovery period.
Under either alternative, the taxpayer can deduct $1 million. By claiming a casualty loss, however, the taxpayer must recover the resulting $1 million basis over 15 years, instead of the remaining five years of the recovery period. Clearly this intended application of the casualty loss rule poses a harsh economic penalty on taxpayers.
Taxpayers who are caught in this predicament have a strong case that the casualty loss rule is contrary to congressional intent, unsupported by statutory authority, contrary to long-standing case law, and simply bad tax policy. All of these support the position that the taxpayer is entitled to claim a $1 million casualty loss. The determination of whether the taxpayer also can deduct the $1 million repair cost arguably depends on whether the cost of the repair is a capital improvement to the property under general tax principles, irrespective of the casualty loss. (For example, if the repair improved the property as compared to its condition before Hurricane Sandy, the repair would constitute a capital expenditure. See Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333, 338 (1962).) Taxpayers considering claiming a casualty loss must carefully evaluate the ramifications of the temporary regulations.