Following the August earthquake in Northern California, individuals and businesses may be assessing their current insurance coverage. Regardless of whether people are insured for natural disasters, differences exist in how losses are treated under the tax code.
Clients may be interested in learning about some basic tax considerations when dealing with these types of losses.
- A personal casualty loss is the lesser of the difference between the fair market value of a property prior to and after the casualty, or the “cost basis” of the property. Clients need to deduct any insurance proceeds from the loss. Then they may deduct the loss as an itemized deduction to the extent that it exceeds 10% of their adjusted gross income.
- For a business casualty loss, the rules are the same unless the property’s fair market value before the loss is less than the cost basis. Then the loss is the cost basis. Also with a business casualty loss, there is no 10% limit for a sole business owner.
From a planning perspective, the loss deduction may exceed income, creating a net operating loss (NOL). Taxpayers in this position, however, may have an opportunity to use a Roth IRA conversion to realize income that could be used to offset the casualty loss deduction. If the income from the conversion is offset by the loss, the business owner may not incur any tax liability. And there is no limit to the amount of income that can be offset by a NOL.
To learn how a net operating loss may be transformed into tax-free income, read “Four year-end planning ideas.”