As tax attorneys, we are taught to see loss as a number. Loss is malleable: losses are captured, losses are spread over a period of years, and losses can be a benefit to our clients. The term loss, however, means something different to tax attorneys than it does to others. To victims of natural disasters, a loss is not a number, but something that is felt; it is something that is grieved.
On March 22, 2014, the small rural community of Oso, Washington suffered the deadliest landslide in U.S. history.1 The landslide itself covered one square mile along State Route 530, damming the Stillquamish River and causing severe flooding to the surrounding area.2 Forty-three people died because of the landslide, and forty-nine homes were consumed. Flooding damaged dozens more.3 Washington State and FEMA declared a State of Emergency almost immediately,4 and President Obama declared a federal disaster on April 2, 2014 as the death toll and the extent of the devastation continued rising.5 FEMA provided more than two million dollars of individual and household program assistance and 27 million dollars of public assistance grants.6
The residents of the slide area needed assistance of all kinds, and Snohomish County Legal Services7 did its part by sponsoring a clinic to aid the victims of the SR530 landslide. The clinic was held at a small chapel located less than a mile from the slide zone—the same chapel where President Obama spoke following the disaster. A group of attorneys and CPAs gathered there to meet the victims and help them if they could. Some of the victims had appointments, some walked in, but all had questions about how the tax laws would characterize their losses.
In the aftermath of an overwhelming tragedy, victims of natural disasters almost always face certain questions that most people need never consider in their lifetimes. These questions relate to traumatic life events that carry with them additional worries about tax consequences. Is the aid that city, county, state and federal governments or charities have provided treated as includible income? What about the mortgage on that destroyed home for which the bank forgave the remaining balance due—is mortgage forgiveness taxed? What if the assistance comes in the form of payments to repair or rebuild property that was destroyed by the disaster—is that income? These are the kinds of questions to which any group of attorneys dealing with victims of natural disasters will need to respond with practical, easy to understand information about the rules that apply and how they affect disaster victims.
I. Is Aid Includible in Victim’s Income?
Victims of natural disasters receive aid from a number of sources, including local governments, FEMA, the Red Cross, and other non-profit organizations. Payments from these organizations can be for food, temporary housing, medical supplies, and other living expenses or they can assist victims in replacing or repairing damaged or destroyed property.
Victims of federally declared disasters—such as the SR530 landslide—receive tax protection under section 139 (titled “Disaster Relief Payments”). That section provides that qualified disaster relief payments are excludable from the recipient’s income.8 These payments are not subject to employment taxes such as Medicare, Social Security, or federal unemployment taxes, and no withholding applies to these payments.9 Qualified disaster relief payments are amounts paid “to or for the benefit of an individual” as a result of a federally declared disaster for living or funeral expenses or repairs and replacements of homes and contents damaged or destroyed by a “qualified disaster,” or paid to an individual from common carrier businesses when a death or personal injury is a result of a “qualified disaster,” or paid by federal, state or local governments or agencies for the public welfare in connection with a “qualified disaster.”10
Under this provision, for example, those FEMA payments to individual victims are not taxable income to the extent the payments did not cover expenses otherwise covered by insurance proceeds. Similarly, cash assistance through section 501(c)(3) charitable organizations to cover disaster victims’ personal expenses and assist with the repair of their residences are not income to the taxpayer victim.11
II. What Are the Tax Consequences in Respect of Property Losses?
Natural disasters can affect property in any number of ways: property can be directly demolished or destroyed, or property can be at risk of future ecological consequences. Aside from the emotional impact that property damage can have on victims, this damage and risk of future damage can diminish the value of property and thus affect the tax treatment of transactions in connection with that property in the future.
A. What is the relationship among property destruction, insurance recovery, and the exclusion of gain on a principal residence?
If a disaster victim’s principal residence is destroyed, the destruction may be treated as a sale for purposes of the tax provisions governing the exclusion of gain from the sale of a principal residence. The victim may recognize gain, however, to the extent that insurance proceeds or other compensation received for the property exceed the taxpayer’s basis in the property.12 Under section 121, gain may be excluded up to $250,000 ($500,000 for married filing jointly) so long as the house was the taxpayer’s primary residence for two of the past five years.13
Additionally, because the destruction is considered an involuntary conversion of the residence, any gain in excess of the $250,000/$500,000 section 121 cap may also be deferred by buying similar or related replacement property under section 1033, so long as:
1) The gain is used to purchase property that is similar or related in service or use to the home; and
2) The purchase is made within 2 years (or 4 years after any payment is received if the receipt of insurance proceeds or other payment is deferred).14
B. What is the tax consequence when debt on property is forgiven?
A natural disaster does not necessarily come with debt relief. To the extent mortgages, credit card debt, and car loans are forgiven, however, disaster victims may be subject to tax on cancellation of debt income (“COD income”) unless an exception under section 108 applies. These exceptions include insolvency and bankruptcy, and qualified principal residence indebtedness income.15 This latter exception, originally enacted in the Mortgage Forgiveness Debt Relief Act of 2007 as a temporary provision, extended through 2014 and then again recently extended through 2016, allows taxpayers to exclude up to $2 million (if married filing jointly) of COD income on their principal residence.16 “Qualified principal residence indebtedness” is debt secured by and used to buy, build, or substantially improve the taxpayer’s principal residence.17
This exception is particularly important for victims of natural disasters for two reasons. First, the application of this exception is efficient since it can apply in a number of circumstances likely to arise as a consequence of a major natural disaster. As a result of floods, tornados or landslides, some victims abandon their property because it is unsafe to return; some victims give up their property under provisions for deed in lieu of foreclosure because the value of the property has dropped so drastically that it cannot be sold; and some face foreclosure. In each of these situations, the exception for income from cancellation of qualified principal residence debt provides relief from what would otherwise be an additional burden of likely tax liability for disaster victims.
Second, from a policy perspective, excluding qualified principal residence income from COD income provides genuine financial protection for victims. Excluding qualified principle residence income under these circumstances would prevent disaster victims from receiving big tax bills at the very time he or she is scrounging for assets to meet immediate needs after the emergency. Otherwise, this could comes at a time when a victim has no assets with which to pay the tax on what seems, at this point, like phantom income.
Finally, it is worth noting that this protection is limited. The protection only insulates a taxpayer on the sale of the taxpayer’s true home (in tax jargon, the “principal residence”): other debt that is forgiven in connection with a disaster, even debt on a vacation home that is eligible for some interest deduction benefits, will be treated as COD income subject to tax. Furthermore, this exclusion is still a temporary provision, reflecting the view that the 2007-8 financial crisis created an especially difficult situation for many homeowners because of the high rates of mortgage indebtedness coupled with significant reduction in housing prices across most of the United States.
C. How does a taxpayer calculate tax losses from damages to property?
Disaster victims facing damaged property in need of repair who continue to have compensation and other income may be able to take advantage of a casualty loss in respect of the property under section 165(c)(3) for the taxable year that the disaster loss is suffered. In general, a casualty loss is a loss due to a sudden, unexpected, or unusual event such as fire, storm, terrorist attack, or vandalism.18 The amount of the overall casualty loss is the decrease in fair market value of property due to casualty damage; but the amount permitted to be taken into account cannot exceed the taxpayer’s basis in the property.19 Additionally, insurance or other reimbursements reduce the amount of the casualty loss.20
To determine the amount of a casualty loss the taxpayer must:
1. Determine the adjusted basis in the property before the casualty;
2. Determine the decrease in fair market value of the property as a result of the casualty; and
3. Subtract any insurance or other reimbursement (such as FEMA payments specifically for property) received from the smaller of the amounts determined in steps one and two.21
The reduction in the amount of the casualty loss in step 3 does not, however, include any proceeds from insurance or FEMA (or similar agencies) that are used to provide for temporary living expenses in the wake of a natural disaster. It is therefore very important for victims to ascertain the purpose of any aid and insurance payments they receive.
The tax law also provides additional limitations to the casualty loss that can be reported on a victim’s tax return. Under section 165(h)(1), the first $100 of the casualty loss is not permitted as a deduction. Moreover, section 165(h)(2) allows personal casualty losses to the extent of any personal casualty gains, but permits a taxpayer to take a net casualty loss into account only to the extent it exceeds 10 percent of the taxpayer’s adjusted gross income. These limitations reduce the tax benefit of the loss, but nonetheless the law provides important support for victims of theft or casualties.
Finally, section 165(i) provides a measure of flexibility regarding the timing of use of casualty losses for victims in federally declared disaster areas. Under that section, the disaster victim may elect to take the loss into account for the taxable year immediately preceding the taxable year of the disaster. This ability to amend the prior year’s return to take a casualty loss may provide much needed, immediate income in the form of a tax refund, especially for victims whose jobs have been stalled by the disaster, such as fishermen and waitresses in the areas affected by the BP oil spill or loggers in an area devastated by forest fires. Applying a casualty loss in the prior year may also mean more tax relief than would be available if the casualty loss were claimed in the year of the disaster.
III. What Do You Tell a Victim After Loss?
As discussed, there are several strategic decisions disaster victims must make about their losses to mitigate tax consequences. In Oso, those who volunteered could help victims understand the application of the rules discussed in this article about casualty losses, debt forgiveness, and exclusion of charitable or governmental assistance. At the chapel in Oso that afternoon, however, many of the victims did not come with questions about tax planning that could be answered with straightforward application of these rules. Their questions had more to do with how to take the next steps to deal with the loss of a home, its contents, and loved ones. Many victims wondered how to document the most basic facts of their new financial situation. Questions revolved around how to find a loved one’s mortgage, and how to determine the basis of a home when all the records were destroyed. There were no easy answers for such questions.
The loss that these victims felt was more than just a number that could be entered on a tax return. Working with landslide victims that morning at the Oso Tax Clinic, volunteer attorneys heard stories of tragedy, bravery, and resilience. We hope the Tax Clinic and our efforts helped in some small way to contribute to the peace of mind of these courageous residents of Oso. ■
2 See Mudslide Survivors, Rescuers Tell Their Stories of Tragic Day, Seattle Times (Mar. 29, 2015).
3 See id.
4 Disaster Resources, Washington State Oso Mudslide Resources, March 25, 2014 (describing various agency responses to the emergency and emergency assistance available).
5 ICTMN, President Declares Major Disaster in Oso, Washington as Landslide Deaths Reach 29 (Apr. 3, 2014).
9 IRC § 139(d).
11 IRC §139(a), (b). The Service formerly took a narrower view of what constituted charitable assistance not subject to taxation, limiting it to assistance to the poor to meet basic needs; but in the aftermath of the September 11, 2001 terrorist attack on New York City and the later anthrax attacks that same year, the Service broadened its interpretation of the kinds of needs for which a charity could provide cash assistance without regard to the financial status of the victim to include such things as assistance allowing a surviving spouse to remain at home with young children; assistance with elementary, secondary, and higher education costs; assistance with rent; mortgage payments or car loans that help prevent further loss and trauma to families; and travel costs for family members to attend funerals and comfort survivors. See IRS Pub. 3833, Disaster Relief: Providing Assistance Through Charitable Organizations (2002) (applying a “needy and distressed” test). See also IRS Pub. 3833 (rev’d Dec. 2014). The terrorist attacks also led Congress to pass legislation to provide special relief for victims: the Victims of Terrorism Tax Relief Act of 2001, Publ. L. No. 107-134 (Jan. 23, 2002), added section 139 to the Internal Revenue Code, among other changes. The explanation of the Act made clear that exempt organizations’ cash relief to victims for this broader definition of needs was covered.
13 IRC §121.
14 IRC §1033.
15 IRC §108.
16 Tax Increase Prevention Act of 2014, Publ. L. No. 113-295 (2014) (extending the provision through the end of 2014); Protecting Americans from Tax Hikes Act, Publ. L. 114-113 (2015) (in Division Q of the Act, excluding discharges through 2016 and after 2016 if there is a binding written agreement before January 1, 2017).
17 IRC §108(h) (referring to section 163(h)(3)(B)’s definition of acquisition indebtedness). See also Mark Keightley & Erika Lunder, Analysis of the Tax Exclusion for Canceled Mortgage Debt Income, Cong’l Res. Ser. (RL34212, Dec. 30, 2015).
19 Treas. Reg. §§1.165-1(c)(1), 1.165-7(b).