It is often said that bad things happen in threes. This is a nice way of saying that too many bad things have happened in quick succession, so hopefully, the person will not suffer further calamities in the short term.
Tax attorneys view calamities in terms of tax losses and/or net operating losses. As tax attorneys in Houston, we spend a lot of time on these rules. The Houston metro area has experienced its share of calamities. This includes multiple recent storm events, such as Hurricane Harvey and the Winter Storms. Before that, it was Hurricane Ike. There was the mortgage-induced financial crisis and the dot.com bust. There is the covid pandemic that the nation is experiencing. And there have been several economic busts tied to the oil and gas industry. These are in addition to other situations that trigger tax losses, such as gambling losses, poor financial decisions, and business losses.
The ability to deduct demolition costs is one aspect of casulaty-induced tax losses. The Parker v. Commissioner, T.C. Memo. 2021-111, case provides an opportunity to consider demo expenses in the larger context of losses for the destruction of buildings.
Facts & Procedural History
The taxpayer purchased a house in 2008, sight unseen. He paid $17,000 for it.
When he intended to reside in the property, but this intent changed when he first visited the property. He then tried to rent out the house but was not able to find a tenant.
The taxpayer cancelled the insurance policy on the house two years after purchasing the property, in 2010. Four years later, in 2014, vandals burned the property down.
The taxpayer paid $10,000 to demolish the structure in 2015 and kept the land.
The taxpayer then reported this $10,000 demolition cost on his Schedule E, Supplemental Income and Loss, on his 2015 income tax return.
The IRS audited his tax return and disallowed the loss. Tax litigation ensued.
Deductibility of Demolotion Costs
The IRS disallowed the demolition cost expense pursuant to Section 280B. Section 280B says that demolition costs for a building structure are not immediately deductible. Instead, the amount of the loss is to be added to the basis of the land that the structure was situated on. This increased tax basis offsets gain if and when the taxpayer sells the land. The taxpayer did not sell the land in this case.
The taxpayer agreed with the IRS that the loss should not be reported on his Schedule E. He contended that the loss should be reported on Schedule A, Itemized Deductions, as a casualty loss.
The taxpayer cited IRS Notice 90-21, 1990-1 C.B. 332. This notice deals with a loss incurred on the property. The notice provides timing rules for when there is a loss due to a casualty event and then there is a loss due to demolishing the damaged structure. What it says is that the amount of the loss on the casualty is computed first by reducing the basis in the structure by the amount of the loss. Then, you can compute the loss on demolition. It does not say that the demolition costs are deductible as the taxpayer argued.
As a result, the court denied the taxpayer’s deduction for the demolition costs. It also could not allow the casualty loss issue raised by the taxpayer as the loss was incurred in a prior year.
Tax Issues for Demolished Buildings
While the taxpayer lost this issue in the court case, he did not necessarily lose out on the tax benefits he was seeking. There are several issues that have to be considered in situations like this.
First, the Tax Cuts & Jobs Act changed the ability to take casualty loss deductions. Only personal casualty tax losses that are due to a Federally declared disaster are allowable. The Cares Act temporarily suspended this requirement, but it comes back from 2021 through 2025. These rules are not addressed in this court case involved tax years that pre-date these rules. For losses during these years, the taxpayers have to navigate these extra rules. The same laws also changed the ability to carry back net operating losses. These losses may be triggered by large casualty losses. These rules also have to be considered.
Second, Section 280B does not preclude taking a casualty loss for the cost of the building. It just does not allow the demolition costs to be deducted currently. This means that the taxpayer may still be entitled to deduct the casualty loss. He may also be entitled to an abandonment loss under the pre-tangible property regulation court cases. The court, in this case, concluded that the taxpayer picked the wrong tax year for taking the loss. It only had the 2015 tax year before it; the fire happened in 2014. The taxpayer apparently did not argue that he had a pending claim to recoup the loss, as that type of argument might have made the loss allowable in 2015. Regardless, now that the court has ruled in this case, the taxpayer may need to look to the tax mitigation provisions to see if he can still claim the loss. The tax mitigation rules do allow taxpayers to go back and take tax deductions and losses for older tax years.
Third, the partial asset disposition rules might prove to be helpful. These rules apply to depreciable investment and business property. What they say is that one is able to deduct the depreciation on property that is disposed of in the year that the building is destroyed. These rules do not override Section 280B for the demolition costs (at issue in this case), but they can allow the taxpayer to deduct the loss for the cost of the demolished building. To qualify, the taxpayer may have to restore the property and capitalize the costs of the restoration. This is an area where a little tax planning can save a significant amount of tax.
Even though the taxpayer was not allowed to deduct his demolition costs in this case, this does not mean that he actually lost the deduction. The demolition costs will be added to his tax basis and he’ll be able to deduct them at some later time.
The taxpayer is still entitled to a tax loss to account for his investment in the building. How he takes this loss depends on the circumstances and how he chooses to report the loss. Given that the IRS frequently challenges tax losses, those who find themselves in this situation should consult with an experienced real estate income tax attorney.
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