What is the income tax treatment of property, casualty, and liability insurance?
In general, individuals and business owners purchase property, casualty, and/or liability insurance to guard against disasters and other risks to property, and also to guard against lawsuits by persons injured on (or because of the use of, or condition of) the property. The tax rules applicable to property, casualty, and liability insurance differ, depending on whether the policyholder is an individual or a business owner. For example, individuals generally must itemize deductions to claim a casualty loss, and the amount of the deduction is limited. For corporations, on the other hand, the entire loss is allowed as a deduction against business income. Both individuals and businesses are required to file timely insurance claims and must offset reimbursements against losses.
What is a casualty?
For federal income tax purposes, a casualty means a loss of property that results from a sudden or unexpected catastrophe that causes direct damage. Examples include damage from hurricanes, lightning, fires, car accidents, vandalism, and snow. Your loss won't be considered a casualty if it results from progressive, steady deterioration, or normal processes.
Example(s): Assume John had lived in his house for many years. His wooden porch had been deteriorating slowly over several years. When John eventually hired an inspector to look at the porch, he learned that termites had caused significant damage over a long period. Although the inspector advised that the porch be torn down and replaced with a new one, John will not be able to claim a casualty loss tax deduction as a result of the termites.
If your property is covered by insurance, you should file a timely claim for reimbursement of your loss. In general, a reasonable insurance reimbursement is not taxable to you. If you receive reimbursements, you must subtract them from your total loss. The unreimbursed portion of your loss may be deductible if you meet all applicable conditions. But if the amount of your reimbursement exceeds the loss, you may have to report taxable income.
How do you calculate a business casualty loss deduction?
The rules differ, depending on whether your business property was damaged or destroyed.
General rules
A corporation may deduct the full amount of the casualty loss, assuming there is no reimbursement. To the extent that the money or property you receive as reimbursement for your loss is less than the adjusted basis of the property that was damaged, the business realizes a deductible casualty loss. However, you may not take a casualty loss deduction if you have insurance coverage and decide not to file a claim.
In computing a business casualty loss deduction, three factors are important:
- Your adjusted basis in the property (generally, the property's original cost to you plus the cost of improvements, minus depreciation)
- Insurance reimbursement that you receive or the salvage value
- The fair market value of the property before it was damaged or destroyed (but, if the business property is destroyed, ignore the fair market value and compare basis to insurance reimbursement)
If a property is completely destroyed
What if the property is completely destroyed by a fire or other disaster? Your casualty loss equals your adjusted basis in the property (less any salvage value of the property) minus any insurance reimbursement.
Example(s): The building that Mary Corporation uses for its business was completely destroyed by fire. Before the fire occurred, the fair market value of the building was $90,000 and its adjusted basis was $100,000. Mary Corporation received a $90,000 insurance reimbursement for the loss. Mary Corporation can claim a deduction for its loss of $10,000 (the difference between its insurance compensation and the property's basis).
If a property is damaged
If a property is damaged, but not destroyed by a casualty, the casualty loss equals the lesser of (1) the decrease in the fair market value of the property as a result of the damage, or (2) the adjusted basis in the property immediately before the casualty, less any insurance reimbursements. You'll also need to keep track of your new tax basis on the damaged property.
Example(s): Jack Corporation has a machine with an adjusted basis of $15,000. The machine was worth $20,000 before it was damaged, and was worth $16,000 afterward (a $4,000 drop in value). Jack Corporation received a $3,000 insurance reimbursement for the loss. Jack Corporation may claim a casualty loss deduction for the difference of $1,000. To calculate the corporation's new tax basis in the machine, the corporation must subtract $4,000 (the $3,000 insurance reimbursement plus the $1,000 casualty loss deduction) from its $15,000 adjusted basis in the property before the loss, leaving the corporation with a new adjusted basis in the machine of $11,000.
Casualty gains
It is quite possible to end up with a casualty gain rather than a loss.
Example(s): Say the building owned by your business with an adjusted basis of $80,000 burned down and the insurance company reimbursed the business for the building's fair market value of $100,000. Your business would have a gain of $20,000. The $20,000 gain would be subject to the tax rules for involuntary conversions. Your business could generally avoid taxation of the gain by reinvesting the insurance proceeds in similar property within two years. In that way, no gain would be recognized until the property is sold.
How do you calculate a personal casualty loss deduction?
Note: For 2018 to 2025, you can deduct a personal casualty loss only if it results from a casualty attributable to a federally declared disaster.
A casualty loss equals the lesser of:
- The decrease in the fair market value of the property as a result of the casualty, or
- The adjusted basis in the property before the casualty
However, the casualty loss must be reduced by any insurance or other reimbursement received or that is expected to be received.
You generally must itemize deductions in order to claim a casualty loss. A casualty loss generally cannot be deducted unless the loss exceeds a $100 loss floor, and the combined losses for the year in excess of this $100 floor are deductible only to the extent that such losses exceed 10 percent of your AGI.
Example(s): Assume Jack had a casualty loss of $5,000 and his AGI was $15,000. His casualty loss deduction on Schedule A is $3,400 ($5,000 - $1,500 - $100). If Jack's business had suffered the loss, rather than Jack's, the business would have been able to claim the full $5,000 loss as a business deduction.
As with businesses, you may not take a casualty loss deduction if you have insurance coverage and decide not to file a claim. Therefore, if you have a car accident and don't report it to your insurance agent for fear of a rate hike, you may not take a casualty loss deduction for the damage to your car.
What about property and liability insurance?
There are many different types of property and liability insurance. A typical homeowners policy might offer protection not only against casualties, but also against glass breakage, theft, fire, smoke damage, and damage to personal property. If you live in a flood zone, you may also need to purchase flood insurance. In addition, liability coverage protects you if someone is injured on your property. You may also buy automobile insurance to insure yourself against automobile-related property damage and physical injuries.
As for businesses, professionals (such as attorneys) often purchase malpractice liability insurance to protect against their errors and omissions. Businesses also purchase insurance to cover:
- Damage to (or destruction of) their property and equipment
- Liability (injuries on business premises or due to manufacture or sale of faulty products)
- Crime exposures
The tax rules differ, depending on whether you are an individual or a business owner.
Business
A business is allowed to deduct all ordinary and necessary business expenses that have been properly paid. Therefore, the premiums you pay for property and liability insurance generally may be deducted in full by the business.
Personal
In general, property and liability insurance premiums are not deductible by individual taxpayers. However, if you have a home office or if you own rental property, a portion of your property and liability insurance premiums may be deductible as a business expense.
This article was prepared by Broadridge.
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