By John C. McCoy, Esq.
Arent Fox, LLP, Washington, DC
Many areas affected by Hurricane Sandy have been declared disaster areas pursuant to the Robert T. Stafford Relief and Emergency Assistance Act. (The various declarations can be found at www.fema.gov.). As a result of such classification, a taxpayer who incurred a loss attributable to the hurricane may elect, pursuant to §165(i), to treat the loss as occurring during the preceding tax year (i.e., 2011 rather than 2012).
As explained below (i) in the absence of administrative relief, an individual calendar year taxpayer must make the election no later than April 15, 2013, and the election becomes irrevocable after 90 days and (ii) where the loss was incurred with respect to "personal use property" (i.e., property which was neither used in a trade or business nor held in an activity entered into for profit) the better year to claim the loss may depend on whether or not a specific provision of recently proposed disaster relief tax legislation is enacted.
Election and Revocation Deadlines.
An election to claim a deduction with respect to a disaster loss for the taxable year immediately preceding the taxable year in which the disaster actually occurred must be made on or before the later of (1) the due date for filing the income tax return (determined without regard to any extension of time granted the taxpayer for filing such return) for the taxable year in which the disaster actually occurred, or (2) the due date for filing the income tax return (determined with regard to any extension of time granted the taxpayer for filing such return) for the taxable year immediately preceding the taxable year in which the disaster actually occurred.1 As a practical matter this means that, unless a taxpayer uses a fiscal year ending on or before June 30, the election with respect to disaster losses attributable to Sandy must be made no later than the due date without extensions of the tax return for the taxable year (April 15 in the case of a calendar year individual taxpayer) in which the disaster actually occurred.2
Regs. §1.165-11(e) states: "Such election [to claim the deduction in the preceding year] shall be irrevocable after the later of (1) 90 days after the date on which the election was made, or (2) [a date in the 1970's]…" However, in Matheson v. Comr. 3 (where the taxpayers filed a revocation more than 90 days after making the election but prior to the April 15 due date for their year of the disaster tax return), the Tax Court declared the regulation invalid to the extent it imposed a time limit for a taxpayer's revocation of the election which was shorter than the time for making the election. It reasoned that such a requirement was contrary to Congressional intent because it discouraged taxpayers from making a prompt election and receiving an accelerated refund of the earlier year's taxes.
The IRS acquiesced in result only. It disagreed with the court's reasoning but determined that an appeal was not appropriate because the professed reasons for the regulation's promulgation (administrative convenience and a mistaken belief that a taxpayer could use the funds interest free) were erroneous.4 Despite the IRS's acknowledgment that this portion of Regs. §1.165-11(e) was based on faulty premises, it has not been amended and the current edition of IRS Pub. 547 states, without qualification, that the election can be revoked within 90 days of making it.
Section 7508A authorizes the Secretary, for purposes of determining the tax liability of a taxpayer affected by a federally declared disaster, to specify a period of up to one year that may be disregarded in determining whether certain acts were performed by the taxpayer within the prescribed times. In Notice 2006-17,5 the IRS exercised this authority to extend the period for making a §165(i) election until October 16, 2006, for taxpayers with losses which occurred in the disaster areas declared with respect to Hurricanes Katrina, Rita or Wilma. But there is no assurance that it will do so for Hurricane Sandy. Note: If the IRS exercises the §7508A authority with respect to the filing of tax returns without specifically extending the time for making the §165(i) election, the prescribed time for making the election would not be extended.6
Making or Revoking a §165(i) Election.
A §165(i) election must be made by filing [for the taxable year immediately preceding the taxable year in which the disaster actually occurred] a return, an amended return, or a claim for refund clearly showing that the election provided by §165(i) has been made. In general, the return or claim should specify the date or dates of the disaster that gave rise to the loss, and the city, town, county, and State in which the property that was damaged or destroyed was located at the time of the disaster.7
As noted above, the regulation states that the election becomes irrevocable 90 days after the date on which the election is made. Further, no revocation of such an election is effective unless the amount of any credit or refund that resulted from such election is paid to the IRS within the revocation period. However, in the case of a revocation made before receipt by the taxpayer of a refund claimed pursuant to such election, the revocation shall be effective if the refund is repaid within 30 calendar days after such receipt.8
Whether to Make the Election.
Where, as is the case with Sandy, the loss occurred late in the year, the election's effect on the timing of the refund may be insignificant and the decision can be based solely on whether claiming the loss in the earlier year will result in a larger tax benefit.
If the property giving rise to the disaster loss is described in §165(c)(1) (property used in a trade or business) or §165(c)(2) (property held in activity entered into for profit), the determination of whether making the election will result in the a greater tax benefit will be fairly straight forward. Unless the loss is large enough to create a net operating loss, it is simply a question of which of the two years had the most income taxed at higher marginal rates. If the loss will result in a net operating loss, the different years to which the loss would be carried needs to be taken into account.
Section 165(h)(2) limits the deduction for casualty losses (including disaster losses) with respect to property described in §165(c)(3) (i.e., property not described in §165(c)(1) or (2)) to the excess of the sum of (i) casualty gains on such properties plus (ii) 10% of adjusted gross income (AGI).
In the past §165(c)(3) losses resulting from certain major disasters (e.g., Hurricanes Katrina, Rita and Wilma and May 2007 storms and tornados in the Kansas City area) have been exempted from the 10% of AGI limitation. As of February 14, 2013, no proposed legislation providing such an exemption for losses resulting from Hurricane Sandy is pending,9 but it is possible that such a provision could be proposed and adopted in connection with any changes made to the Code as a result of the ongoing budget negotiations.
If legislation exempting Hurricane Sandy disaster losses is enacted, the factors to be considered in making a §165(i) election decision for a personal use property loss will be the same as with business or for profit property. However, in the absence of such a relief provision, in some situations, claiming the loss in the higher marginal rate year may result in a reduction in the deductible loss that more than offsets the benefit of claiming the loss against income taxed at a higher marginal rate.
For more information, in the Tax Management Portfolios, see McCoy, 527 T.M., Loss Deductions, and in Tax Practice Series, see ¶2350, Losses.
1 Regs. §1.165-11(e).
2 Most, but not all, of the Sandy disaster declarations include portions of both October and November 2012. This may create factual issues for an October 31, fiscal year taxpayer.
3 74 T.C. 836 (1980) (while the court held invalid any time restriction for revoking an election which is shorter than the time for making an election, it did not otherwise comment on what the time limit should be).
4 AOD 1980-177.
5 2006-1 C.B. 559.
6 Regs. §301.7508A-1(b)(4).
7 Regs. §1.165-11(e).
8 Regs. §1.165-11(e).
9 On Dec. 10, 2012, Senators Schumer and Menendez announced they were introducing legislation (The Hurricane Sandy and National Disaster Tax Relief Act of 2012) to reduce taxes on those impacted by Hurricane Sandy, including a provision that would waive the 10% of AGI limitation for all 2012 FEMA major disaster declarations. However, they have not reintroduced the legislation in the current Congress. (A press release describing the provisions included in the December proposed legislation is available at http://www.schumer.senate.gov/Newsroom/record.cfm?id=338083 ).