Eight of the ten most costly disasters in U.S. history have happened in the last 15 years. Some of these—especially 9/11 and Hurricane Katrina—triggered unprecedented tax relief for casualty losses.1 Others, such as Hurricane Sandy, led to no additional tax relief whatsoever.2 That is, Congress’s 21st century post-disaster responses have ranged from multi-billion dollar tax relief targeted at discrete, identified, disaster zones3 to no additional substantive tax relief at all. At the same time, victims of more common casualties, like house fires, lightning strikes, isolated floods, and tornadoes, receive only the limited section 165 casualty loss deduction. Although not as newsworthy, these common tragedies may result in losses to an individual casualty victim at the same or even higher levels than losses suffered by victims of more widespread disasters. Congressional action thus seems to be more dependent on human emotion and political whim than sound tax policy. The increased likelihood of all casualties, coupled with the escalating costs of major disasters (see Table 1), makes reconsideration of the tax treatment of casualty losses a timely and important issue.
Losses from Major Disasters from 1994-2012
- Hurricane Katrina (Aug. 2005)
- Terrorist Attacks of Sept. 11th, 2001
- Hurricane Andrew (Aug. 1992)
- Hurricane Sandy (Oct. 2012)
- Northridge, CA Earthquake (Jan. 1994)
- Hurricane Ike (Sept. 2008)
- Hurricane Wilma (Oct. 2005)
- Hurricane Charley (Aug. 2004)
- Hurricane Ivan (Sept. 2004)
- Flooding, hail, wind, and tornadoes including the tornadoes that struck Tuscaloosa and other locations (Apr. 2011)
This article will first summarize the evolution of the casualty loss deduction as a basis for understanding the problems with its 21st century application. The remaining parts will focus on the proposed remedy of a refundable credit.This article proposes to reform section 165 to create a refundable credit for casualty losses to solve the three most significant problems with current tax policy in this area: 1) disparate treatment of victims of different disasters; 2) higher tax relief for wealthy taxpayers than for the poor; and 3) substantial government relief to those who engage in the riskiest (and potentially costliest) behavior. The refundable credit would be linked to proof of insurance and would be reduced or eliminated for those with uninsured losses. Because the credit is refundable, it would be available to those who take the standard deduction as well as to those who itemize, and it would be provided to the working poor even if they have no tax liability. Finally, it could be phased out for taxpayers in the highest marginal tax bracket, since these taxpayers can best afford to self-insure or to pay to be fully insured.
I. Section 165 Casualty Loss Relief Is Inequitable
The first casualty loss deduction dates back to 1864.6 Between the Civil War and World War II (WWII), all business and personal deductions had to be itemized, and the casualty loss deduction was no exception. During WWII, the standard deduction was introduced as an easier alternative for taxpayers who preferred not to maintain detailed records to justify itemization while still providing a reasonable amount to offset typical taxpayer deductible expenses. The casualty loss deduction has since been codified as an itemized deduction for individuals and businesses under section 165 (except for tax years 2008 and 2009, as described below). Unlike businesses, which may deduct the full out-of-pocket loss for any disaster, individuals are subject to a casualty loss threshold (equal to $100 plus 10% of adjusted gross income (AGI)) before relief is allowed.7 If a single taxpayer has no other itemized deductions, then there is no financial advantage to itemizing in order to claim the casualty loss until the casualty loss exceeds 10% of the taxpayer’s AGI by $6,400 (the 2016 standard deduction plus $100). Taxpayers who are married filing jointly would need to sustain a loss of more than $12,700 plus 10% of their AGI if they had no other itemized deductions. While each taxpayer’s circumstances are unique, it is nevertheless clear that those who already itemize are better positioned under the existing scheme than those with few itemized deductions.
After Hurricanes Katrina, Wilma, and Rita in 2005, Congress waived the $100 deduction limitation and the 10% AGI threshold for individuals in affected areas.8 After Hurricane Ike and the “Heartland Disasters” of 2008, Congress extended similar relief to all individuals in any federally declared disaster area for all of 2008 and 2009.9 This “National Disaster Relief Act of 2008” was the first time Congress prospectively authorized enhanced casualty loss relief for major disasters.10 Because the relief was only afforded to those in declared disaster areas, however, horizontal equity was violated. Taxpayers with identical income and casualty losses faced disparate treatment based solely on whether the casualty itself occurred in a federally declared disaster area. To illustrate, all other things being equal, a single taxpayer in the 28% bracket with $100,000 AGI in a federally declared disaster area would have a tax advantage of $2,900 compared to a similarly situated taxpayer outside of a declared disaster area (each victim suffering similar net casualty losses of over $10,000).11 Although this inequitable treatment expired after December 31, 2009, legislation has repeatedly been proposed over the past few years to extend the waiver of the 10% AGI casualty loss limitation in declared disaster areas.12
Any such extension of the waiver of the 10% AGI casualty loss limitation would also undermine vertical equity, because the section 165 reduction of deductible losses by 10% AGI at least serves as a surrogate for progressivity. Without it, any deduction has an “upside down” quality by allowing more tax relief for taxpayers in higher brackets than those in lower brackets. Without the limitations in section 165(h)(2), for example, a taxpayer in the 15% bracket suffering a $10,000 net casualty loss would obtain up to $1,400 of tax relief; in contrast a taxpayer in the 28% bracket facing the same $10,000 net casualty loss would garner up to $2,900 of relief or nearly twice as much (again applying the taxpayer’s marginal tax rate to determine the deduction available).
This vertical equity flaw was demonstrated in exaggerated form in the IRS Statistics of Income reported for 2008-2009 (the only two years when the 10% AGI limitation did not apply). The average deduction for those with AGI in excess of $10 million was $441,490.13 This grossly exceeds the average casualty loss deduction of $2,000-$16,000 for individuals with less than $200,000 AGI.14 Of course, those with no tax liability after their other deductions and exemptions enjoy no casualty loss tax relief; yet arguably these working poor are the taxpayers who can least afford to fully insure or to bear the burden of their losses without government support.
The final problem with the existing scheme is that those who are most underinsured or uninsured receive the most tax relief. In economic terms, this is known as moral hazard, because these taxpayers are not bearing the full brunt of their risky behavior.
II. Replacing the Deduction with a Uniform Refundable Credit
The value of tax relief afforded by a casualty loss deduction depends on the applicable tax rates of the taxpayers suffering a casualty loss. As a result, those in lower brackets receive comparatively less relief than those in higher brackets (where relief is equal to the tax rate times the allowed deduction). A tax credit, unlike a deduction, reduces taxes dollar-for-dollar. A credit can be capped at the amount of tax relief that the government determines merits a subsidy. Furthermore, a credit can be refundable, meaning that the full value of the credit is payable in cash to eligible taxpayers who have no tax liability.
A. Rationales for a Refundable Credit
There are a number of reasons that a uniform refundable credit would provide a better approach to casualty loss taxation than the current deduction.
First, a refundable credit should reduce the psychological pressure on Congress to allow special tax relief as an attempt to help victims every time an especially salient disaster occurs that garners national attention. As the tales of storms Katrina and Sandy suggest, congressional response to a major disaster fluctuates from no tax relief to multi-billion dollar relief depending on the impact and visibility, political circumstances, and even inurement to tragedy that surrounds a particular disaster. Such a result is almost certain to be inconsistent and unfair as to those who have been involved in major disasters. Moreover, it will always be unfair towards those who suffer similar losses that are not part of federally declared disasters.
Second, the government should provide a real measure of relief for citizens who suffer major casualty losses. Eliminating the casualty loss provision would be problematic, because it would remove the safety net for those it now assists. Providing a refundable credit delivers more assistance to those that need it. If the government is going to allow any tax expenditures to foster social objectives at all, then it should consider the relative merits of the competing measures when deciding which measures to extend and which to curtail. While people may always disagree about the level of social support or security the government ought to offer, most would likely support assistance for victims of tragedy. It appears that there is as strong an argument for them—especially for those in the lower income brackets—as there is for tax relief for families with more children, taxpayers who choose to buy homes (especially second houses), those who overextend on student loans, those higher-income taxpayers who benefit from the exemption for interest from municipal bonds, and others.
Third, a refundable casualty loss credit would, if implemented appropriately, provide an incentive to reduce risk taking and promote responsible behavior. Incentivizing taxpayers to fully insure and to reduce their deductibles would also likely relieve the government of some of the welfare burden it currently shoulders and transfer it to individuals themselves and the insurance industry.15
Finally, the refundable casualty loss tax credit provides a more targeted benefit for lower-income taxpayers and thus provides government assistance for those who most need it. The upside-down value provided by tax deductions and the financial benefit of non-refundable credits provide tax incentives that (i) only accrue to those with taxes remaining due after taking all other deductions and credits into consideration and (ii) provide the greatest benefit to taxpayers with the highest incomes and greatest value of assets to lose in a casualty loss. A refundable credit overcomes those limitations. The refundable Earned Income Tax Credit (EITC) has shown that refundable credits provide quick and efficient support for the working poor. If a similar refundable credit with sufficiently high phase-outs were created to offset verified net casualty losses, the credit could provide genuine support for middle-and low-income taxpayers in a time of loss who would perhaps otherwise face a significant personal financial crisis, while avoiding the substantial payouts to higher income taxpayers who are able to self-insure and are probably able to bear substantial financial losses without significant personal burdens.
B. Preventing Fraud by Verifying Losses
If there is an Achilles heel to the EITC, it is the presumed potential for fraud and abuse by those who are not actually working but pretend to do so to collect the refundable credit. Because any refundable credit provides cash payments to those who owe no taxes, there is a similar incentive for abuse with the casualty loss refundable credit proposal. One way to reduce abuses would be to coordinate the credit with insurance claims. Insurers could be required to file an information report in connection with casualty loss claims. The form would indicate the verified amount of the loss, the amount of the deductible, the amount the insurer paid to the claimant on the loss, and the amount of net casualty loss (or gain) after considering the insurance payment.
The insurance industry is already heavily regulated and has measures in place to combat insurance fraud so the addition of this reporting requirement could easily be satisfied as part of the routine insurance claim verification process. One copy of the form would be reported electronically to the IRS and another could be provided to the taxpayer so they are aware of the information that has been reported and so that they have all of the information they will need to claim the credit. The form could also allow the insurance company to indicate whether the claim arose in a federally declared disaster area, which would streamline processing of the election to take the casualty loss deduction for a preceding year under section 165(i).
C. Proposed Mechanism for a $2,000 Casualty Loss Credit
Let’s consider the way a refundable casualty loss credit of $2000 would perform. A $2,000 credit is in line with the average amount of tax relief allowed in 2008 and 2009 in connection with total casualty losses for taxpayers in all brackets earning under $200,000 AGI.16 (As noted, 2008 and 2009 were the only years when all losses in declared disaster areas escaped the 10% AGI reduction.) This should also provide a good barometer of total cost to the government because this window includes both a very high casualty-loss year and a low casualty-loss year.17 Moreover, it parallels the tax advantage most taxpayers with two children receive from the child tax credit and additional child tax credit. Although some disasters will take a larger financial toll than having two extra mouths to feed and others less, this seems an appropriate “ballpark” starting place for consideration. This also suggests a reasonable cap for the credit of $2000.
The proposed credit could be maximized for taxpayers who are insured and who carry low deductibles by having two $1,000 components: one related to the taxpayer’s deductible (“low deductible component”) and the other related to the total amount of net casualty loss (“underinsured component”). The first $1,000 component of the credit could be claimed by any taxpayer with a deductible insurance payment of up to $1,000. For example, a taxpayer with a $500 deductible would receive a $1,000 credit (rewarding the taxpayer for the low deductible), and a taxpayer with a $1,000 deductible would be entitled to a dollar-for-dollar credit. The low deductible component could be reduced by 50% of the amount by which the deductible exceeds $1,000. A taxpayer with a $2,000 deductible would then receive only a $500 credit and a taxpayer with a $3,000 deductible (or higher) would receive no “low deductible component” credit.
The second component of the credit would be determined as a declining percentage of the amount of underinsured net casualty loss. The underinsured component would reduce moral hazard because it would incentivize taxpayers to buy more adequate insurance. If everyone were fully insured, they would have no net casualty loss other than their deductible. Thus, the amount of net casualty loss approximates the extent a taxpayer is underinsured.
To discourage underinsurance, the second $1,000 component of the credit could be reduced when a taxpayer is underinsured by an unacceptable amount. The median amount of net casualty loss claimed in 2008 and 2009 for taxpayers earning under $200,000 ranges from $8,783 (2008—a high claim year with numerous federally declared disasters) to $14,650 (2009—a low claim year with fewer declared disasters) and provides a rough approximation of typical casualty losses for low- to moderate-income taxpayers. It would be reasonable to select a number on the low end, such as $10,000, as a tolerable level of underinsurance. (A lower number would further reduce the moral hazard.) A second phase-out of this underinsured component of the credit could be added for those with incomes over $200,000, to approximate the rough progressivity of the existing section 165 casualty loss scheme.
To illustrate how the underinsured component of the credit would work, assume a $10,000 underinsurance target and a 10% credit reduction for net casualty loss amounts above this target. A taxpayer with a net casualty loss of $10,000 would receive the entire $1,000 credit. One with a lower net casualty loss would likewise receive ten-cents-on-the-dollar relief (so as not to risk overcompensating individuals with smaller loss claims). For example, a $4,000 net casualty loss would generate a credit of $400; a $9,000 loss would create a credit of $900. For those who are underinsured by more than $10,000, the credit could be ramped down at a rate of 10% of the credit per each additional thousand dollars of casualty loss. Thus, someone with a net casualty loss of $12,000 to $12,999 would receive $800 of the underinsured component of the credit, while a taxpayer with a $15,000 net casualty loss would receive only $500. This component of the credit would be reduced to zero for those with more than $20,000 of uninsured loss.
Combining the two halves of the potential $2,000 credit would generate a maximum refundable credit of $2,000 for someone carrying a $1,000 or lower deductible and suffering a verified net casualty loss of $10,000. A taxpayer with twice as much uninsured loss and the same deductible would only receive a $1,000 credit. A taxpayer with a $3,000 deductible and a casualty loss between $10,000 and $10,999 would receive a $1,000 credit.
III. The Unresolved Insurance Issue for Low-Income Taxpayers
The most common question raised about this idea is “what about people who can’t afford insurance?” The short answer is “I don’t know.” The reason I don’t know is that there are different reasons people may claim to be unable to afford insurance. It may be that a combination of low FICO scores and living in high crime areas makes auto and home insurance unaffordable for lower income people. Alternatively, people may not appreciate or may disregard the risk. Under the flood insurance program, it has been found that people not in a flood zone feel they are not at risk even though 20% of flood losses occur outside of designated 100-year flood plains.18 Some people may simply decide they need the money for something more important—such as a car to get back and forth to work (the most common expenditure for EITC recipients). Others may be recently unemployed: unless money is escrowed to pay home insurance, they may cut insurance protection to pay more immediate costs of food, clothing, job search, school, transportation, etc.
Likely the best starting point for consideration is the EITC itself. Eligibility for the EITC is determined based on the poverty line and what’s necessary to overcome poverty, so perhaps an insurance stipend for all EITC recipients could be paid directly to their insurance companies on behalf of these wage earners in lieu of a credit. Another option would be to increase Federal Emergency Management Agency (FEMA) direct welfare payments to disaster victims, since such FEMA payments are not taxable.19 ■
1 I.R.C. §§ 139 and 1400L were added after 9/11 giving casualty loss relief to individuals who needed humanitarian aid and those who had lost property or loved ones, and creating tax incentives for individuals and businesses in the “Liberty Zone” disaster area. Within a month of Hurricane Katrina, the Katrina Emergency Tax Relief Act (KETRA) afforded $5.2 billion in tax relief to hurricane victims. Joint Committee on Taxation, Estimated Revenue Effects of H.R. 3768, Doc. No. JCX-65-05R (Sept. 15, 2005) (casualty loss deduction was the costliest item at over $2.4 billion). KETRA was followed three months later by the Gulf Opportunity Zone Act (GOZA), expanding the nature and scope of relief to GO Zones affected by Hurricanes Katrina, Rita, and Wilma. Pub. L. 109–135, title I, §§ 101(a), 102(a), 201(a), Dec. 21, 2005, 119 Stat. 2578-2607(adding I.R.C. §§ 1400M, 1400N, 1400O, 1400P, 1400Q, 1400R, 1400S, and 1400T).
2 Legislation that stalled in committee in 2015 would have retroactively extended tax relief from 2012 (the year of Hurricane Sandy) to Dec. 31, 2015. National Disaster Tax Relief Act of 2015, S. 1795, 114th Cong. (as referred to S. Comm. on Finance, July 16, 2015).
3 See e.g. JCX-65-05R, supra note 1.
4 Insurance Information Institute, Catastrophes: U.S., Top 10 Most Costly Catastrophes, United States (Property losses not including flood damage covered by the National Flood Insurance Program (NFIP) (emphasis added).
5 Id. (adjusted for inflation using the GDP implicit price deflator).
6 The Casualty Loss Deduction and Consumer Expectation: Section 165(c)(3) of the Internal Revenue Code, 36 Univ. of Chicago L. Rev. 220 (1968) (Editors).
7 Compare I.R.C. § 165(c)(1-2) with I.R.C. § 165(c)(3).
8 GOZA, Sec. 201(a), 119 Stat. 2604 (Dec. 21, 2005) (enacting Code section 1400S(b)); Heartland Disaster Relief Act of 2008, Pub. L. 110–343, div. C, title VII, Sec. 706(a)(1), (2)(A)–(C), (c) (Oct. 3, 2008).
9 Basically, a federally declared disaster occurs whenever the President declares an area a National Disaster Area under the Robert T. Stafford Disaster Relief and Emergency Assistance Act. I.R.C. § 165(i)(5).
10 I.R.C. § 706(a).
11 This amount is determined by applying the 28% marginal tax rate to the entire casualty loss deduction.
10% x $100,000 x $28% = $2,800 + $100 = $2,900.
12 See e.g. National Disaster Tax Relief Act of 2015 (S. 1795), Sec. 103; National Disaster Tax Relief Act of 2014 (S. 2634), Sec. 103.
13 IRS, SOI Table 2.1, 2008, 2009. This number combines the total casualty losses taken by those with AGI over $10 million in 2008 ($32.415 million) and 2009 ($13.5 million) by the 104 total taxpayers (90 taxpayers over $10 million annual income in 2008 and 14 in 2009). $45,915,000/104=$441,490.
14 See id. Calculations are more elaborate for those earning less than $200,000 AGI, because each level of AGI listed in Table 2.1 had to be calculated individually. For example, there were 89,357 and 30,589 taxpayers in the $100,000 to $200,000 bracket in 2008 and 2009, respectively. These taxpayers claimed deductions of $921.150 and $754.472 million, respectively. The total claimed over both years was $1.675622 billion. This number was then divided by the total number of taxpayers claiming in both years (119,946), yielding an average of $13,969.80. The same process was applied to all the AGI categories listed in Table 2.1 to come up with the range of $2,000 to $16,000.
15 I.R.C. § 139 makes FEMA and other government relief as well as disaster relief received from nonprofit agencies, like the American Red Cross, exempt from taxation regardless of the income of the victim.
16 Using 15% times the total amount of the deductions for all taxpayers with AGI of under $200,000 resulted in $1,317-$2,197 of tax relief for each casualty loss filer in 2008 and 2009. Calculations on file with author.
17 This statistic is calculated for the average amount of tax relieved assuming all taxpayers received the full benefit of the deduction at a 15% marginal rate (the statistics tracked by the IRS for this deduction are broken into increments based on AGI, not tax bracket, so some individuals may have been in a higher or lower bracket and some may have been unable to deduct the full amount of casualty losses because their tax obligation was less than the tax relief generated—in other words, their tax obligation may have been eliminated without need of the full advantage of the deduction).
18 See, e.g., Floodsmart.gov, Understanding Your Risk. “[T]he apparent inability of the floodplain designation to effectively capture the likelihood of property damage and potential loss of human life in coastal areas has left potentially millions of property owners unaware of the flood risk and unprepared to mitigate their adverse impacts.” W.E. Highfield et al, Examining the 100-year floodplain as a metric of risk, loss, and household adjustment, National Center for Biotechnology Information (May 22, 2012).
19 Thoughts or suggestions on these issues from low-income tax clinics and practitioners who help low-income clients on a pro bono basis are welcome.