Casualty losses are often challenged by the IRS, as they meet the “large, unusual, or questionable” (“LUQ”) standard for pulling returns for audit.
On audit, the IRS insists on an appraisal from a third party that shows the difference in fair market value before and after the casualty event. Even if an appraisal is provided to the IRS auditor, the IRS will frequently challenge the appraisal. Luckily, the higher standards for appraisals for charitable donation deductions do not necessaly apply to casualty losses.
The absence of an appraisal will almost certainly result in a full disallowance of the casualty deduction on audit. This is one of the instances where the IRS kicks the can down the road to IRS Appeals–knowing that IRS Appeals will likely settle the issue for a percentage even though the taxpayer may have other records that are similar to or even better than an appraisal.
And then there is the court process. The courts do not always require an appraisal. The recent Ricey v. Commissioner, T.C. Memo. 2023-43 confirms that an appraisal is not always needed and explains what other evidence should be presented in the absence of an appraisal.
Facts & Procedural History
The taxpayers claimed a casualty loss of about $640,000 on their vacation home in Stone Harbor, New Jersey on their 2017 tax return due to damage caused by Winter Storm Stella. This storm resulted in the tide level being over seven feet in some parts of coastal New Jersey. This resulted in shore flooding.
The taxpayers in this case reported a fair market value of of their real estate as $2,677,650 before the storm and $1,994,175 after the storm. They subtracted a reimbursement of less than $40,000, which may have been from FEMA funds (the case does not say), from the difference between the home’s reported value before and after the storm to calculate the casualty loss. As the loss was less than their home’s basis of $2,450,000, they claimed the entire amount of the loss on their tax return.
On audit by the IRS, the IRS proposed to disallow the casualty-loss deduction and issued a notice of deficiency. The taxpayers filed a tax court petition. The court considered the evidence presented to show how the storm damaged the taxpayer’s property.
About Casualty Losses
The IRS often challenges casualty losses reported by taxpayers. A casualty loss is a deductible, nonbusiness loss arising from events like fire, storm, shipwreck, or theft. It may even include gambling losses.
To qualify, the loss must involve physical damage, be proximately caused by a sudden, external event, and not result from progressive deterioration. Losses due to decreases in property value or future fears are not deductible.
To calculate the deduction, the taxpayer must determine the difference between the property’s fair market value before and after the casualty. However, the deductible amount is subject to several limitations, such as:
- Deductibility only in the year the loss occurred
- Deductibility only if exceeding $100
- Deductibility only if exceeding 10% of the taxpayer’s adjusted gross income
- Deductibility limited to the property’s adjusted basis
- Deductibility only if the taxpayer is uninsured or filed a timely insurance claim
A competent appraisal is generally required to ascertain the difference in fair market value. In some cases, trade-in values or repair costs may be used instead. Estimates, dealer discounts, and listed prices are not considered persuasive evidence.
This court case helps explain what evidence is acceptable absent an appraisal.
Evidence in the Absence of an Appraisal
The photos of the storm damage were taken on the taxpayer’s phone approximately six years prior. Since the taxpayer could not produce these old photos at trial, the primary evidence in this case included photorgraphs of the construction of the house that were taken after the storm and the taxpayer-husband’s own testimony.
The court did not accept the taxpayer-husband’s testimony as he had initially failed to show up for the trial on the trial date. The wife also failed to show up. The taxpayer-husband was allowed to testify the next day by zoom. The court’s opinion notes that the no-show colored its decision in the case.
The taxpayers in this case did not get an appraisal. To support their case, on audit, they consulted with a real estate agent and obtained multiple-listing service (“MLS”) records of comparable sales.
The MLS records suggested that the value of the real estate was higher before the storm and flooding than it was after. Those who have experienced damage from major storms know that this is true. Real estate that has flooded or had storm damage does tend to sell for less even long after the storm is gone and the damage is repaired.
The court started by noting the difference between an appraisal and, on audit, obtaining records to support the taxpayer’s own estimate of value:
We conclude from this that the values reported on the return were not a result of an appraisal, but rather of the couple’s own estimate. And the MLS printouts are not an appraisal at all, but rather a rationalization of the couple’s guess about the before and after values of their home.
The court then notes that the taxpayer’s own appraisal may sometimes be sufficient:
It’s not impossible for a homeowner to conduct an appraisal himself—but he has to show sufficient knowledge of the property and its value immediately before and after the casualty event. In Coates, 112 T.C.M. (CCH) at 474, we found that a landowner who had worked on his ranch for more than 30 years did have sufficient knowledge to adequately appraise it—especially since he also had substantial experience in buying and selling property in the surrounding county.
The testimony did not convince the court that the taxpayer had sufficient experience or expertise to offer his lay opinion as to the value:
We don’t find a similarly granular knowledge of a local market here. Richey and Cleary had their primary residence in suburban D.C. and they did not spend most of their time at their vacation home. They also produced no evidence of their awareness of market conditions in Stone Harbor. See id. What we got were photographs of MLS printouts. Two were printouts for properties that Richey claimed were comparable to their home before the storm—the first of which showed a sale price of $2,526,950 from April 2017; and the second of which showed a sale price of $2,125,000 from December 2017. Richey then adjusted those prices himself because he said these comparables were smaller and, he claimed, his home was in a more desirable area. These adjustments let him come up with a “before” value of his own home of $2,677,650.
He also pointed to two other properties that he referred to as “lot-value (tear-down)” properties. The purchase prices for these two properties were $1,790,000 and $1,640,000. He argues that these two properties are good comparables for the home’s “after” value, and justify a $1,994,175 after-storm value because the “flood events and future threat required the property to essentially be rebuilt or totally renovated.” We do not find this to be a persuasive appraisal. We infer from Richey’s having to reach out to an agent to give him such comparables an unspoken admission that he is not qualified to conduct an adequate appraisal on his own. We also can’t believe the assertion that the storm damage and fear of future flooding rendered their vacation home a teardown. Richey claimed that no one would buy their home after the storm without considering the cost of a total rebuild of “the retaining walls (from the sea), dock system, and foundation of the home, which suffered significant erosion.”
Given this, the court concluded that the evidence was insufficient to establish that there was a loss.
The taxpayers were not allowed to take an immediate casualty tax loss. However, this does not mean that they cannot benefit from the loss. The disallowed loss will be realized once the property is sold.
Despite the IRS’s frequent assertions to the contrary, this case shows that an appraisal is not always needed. If the taxpayer does not obtain an appraisal, they should have evidence that they consulted with an appraiser or gathered evidence before they report the loss on their tax returns. This may include MLS records and even broker letters as to value. The evidence should also include specific evidence showing that the taxpayer has near-expert knowledge or is very knowledgeable about real estate and values in the local area.