Friday, October 28, 2016
This week I began the fall tour of various parts of farm country with tax seminars for practitioners. It’s always an enjoyable time to visit with the tax pros and listen to them talk about the tax issues they are dealing with for their clients. This week was the western Kansas swing. These practitioners are the salt-of-the-earth professionals that put in a great deal of effort for their clients, many of which are involved in agricultural production. They also perform a great service to their local communities.
One of the issues that seemed to recur this week involved farm casualty and theft losses. So, that’s the focus of today’s blog post.
Casualty and theft losses are important because of the exposure of farm property to the elements as well as exposure to those who might steal. The basic first principle is that casualty and theft losses are deductible regardless of whether the property is used in the trade or business, held for the production of income or held for personal purposes although the rules differ slightly on how the loss is calculated.
A casualty loss is the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. So, for example, you can’t take a casualty loss deduction for “buyer resistance” to your farm because your neighbor had wind towers put up, or the feds determined that your property has jurisdictional wetlands on it, or it happens to be located near a murder suspect (all actual cases). The issue in a particular case comes down to drawing a line. The line is between what is a casualty and what is ordinary wear and tear. If, for example, a farmer or rancher fails to screw the drain plug into a crankcase and loses all of the oil, or failed to put any oil in the crankcase after draining it and starts down the road, is that a casualty loss or is that ordinary wear and tear when the engine is ruined? In this situation, it really comes down to whether there was willful negligence. If not, then the loss is probably a casualty loss.
In the farm and ranch setting, there are a number of cases involving the improper use of herbicides, flood, frost and freezing, insect damage, drought, fire and wind, all of which are examples of casualty where damage was caused. If the taxpayer can successfully demonstrate that such losses were sudden, unexpected and unusual, the losses will be deductible if the loss was not caused as the result of willful negligence. Losses because of disease or termite damage, for example, are generally not eligible for casualty loss treatment because the loss is progressive rather than sudden. For example, Dutch Elm disease has been repeatedly rejected as a cause of a casualty loss along with most other tree diseases as well.
Theft, on the other hand, is the criminal misappropriation of property. Theft includes larceny, robbery and embezzlement. In one case, an individual purchased a farm, under a sale contract which specified that the well on the premises was a “good producing water well.” Shortly after the buyer obtained possession of the premises, the well went dry. The buyer argued in court that he had suffered a theft loss because the seller misrepresented the well. The court rejected the buyer's argument, ruling that no theft had occurred. The court ruled that there may have been fraud or misrepresentation but not theft giving rise to a deduction. It is usually quite difficult for an event to be considered a theft unless there has been a criminal taking of property as determined by state law. However, courts will allow a theft loss deduction for investors who were defrauded in a real estate investment scheme.
Theft losses are only deductible in the year of discovery rather than the year that the theft occurred. This fact has proved to be one of the major stumbling blocks in the ability to deduct for losses attributable to theft. Many times, people wait around thinking they will find the item that has come up missing, or that it will be returned, only to discover too late that the property was stolen and is not now deductible. Casualty losses, alternatively, are deductible only in the year the damage occurred.
The amount of the deduction for both casualty and theft losses is the lesser of (1) the difference between the fair market value before the casualty or theft and the fair market value afterwards and (2) the amount of the adjusted income tax basis for purposes of determining loss. Obviously, with theft, the item is gone, so the fair market value afterward is zero. Thus, the deductible theft loss is equivalent to the fair market value of the item immediately preceding the time of the theft. However, the deduction can never exceed the basis in the item. Hence, the loss attributable to theft or casualty is the lesser of the difference of the fair market value before and after or the basis in the item. In effect, the measure of the loss is the economic loss suffered limited by the basis.
A similar principle applies for crops lost immediately before harvest due to a catastrophic event. If the taxpayer deducted the cost of raising the crop, the income tax basis in the crop is zero and the deductible loss is zero. The part that has been through the tax mill once cannot be run through a second time.
For property held for non-business use, the first $100 of casualty or theft loss attributable to each item is not deductible. The deduction is also limited to the excess of aggregate losses over 10 percent of adjusted gross income (unless the loss was a result of certain hurricanes). Since 1983, non-business losses have been deductible only to the extent total non-business casualty and theft losses exceed 10 percent of the taxpayer's adjusted gross income. However, each casualty or theft loss of non-business property continues to be deductible only to the extent the loss exceeds $100.
Personal casualty gains and losses (from non-business property) are netted against each other. If the losses exceed the gains, all gains and losses are ordinary. Losses to the extent of gains are allowed in full. Losses in excess of gains are subject to the 10 percent adjusted gross income floor. All personal casualty losses are subject to the $100 floor before netting. If the personal gains for any taxable year exceed the personal casualty losses for the year, all gains and losses are treated as capital gains and losses.
Unfortunately, casualty and theft losses are not that uncommon for farmers and ranchers. But, for those that sustain them, the tax rules do allow a recovery through the tax code of some of the value that has been lost.