Basis adjustment for repairs of casualty loss of rental property

[investor85]

I have a rental property with $210,000 cost basis. I had a casualty loss (Hail) in 2021 partly covered by insurance.
Roof needed replacement and exterior components like AC, window screens and garage door were damaged
Total loss is 16k. Insurance paid 14k. 2k is my deductible. 
I made all the repairs and paid the contractor 16k.

I will claim the casualty loss deduction of 2k (16k-14k).
I will reduce the basis of my property to 194k = 210k -16k

Question: Should I enter 16k as a separate depreciable asset for restoration and leave the basis to 194k OR should I increase the basis to 210k accounting for the restoration?
In other words, will there be two depreciable assets or just one on my depreciation report?

(I have searched IRS Pub 547, 551 and 946 and am unable to get a clear understanding of this.)

[M-MTax]

Not sure if this will make it clearer....https://www.thetaxadviser.com/issues/2018/may/casualty-losses-expenditures-sec-162-165.html.

You shouldn't touch basis. The FMV hasn't changed because you were reimbursed by insurance.

[investor85]

I think that the basis should remain unaffected as per Rev Rul 71-161

https://www.irs.gov/pub/irs-utl/am2006006.pdf
Casualty Loss Hurricane Sandy

However, I need someone to confirm this.

[DanielV01]

The basis is normally adjusted.  And then from there it gets complicated because until the property is depreciated for the remainder of its useful life, those depreciation calculations are done manually.  You can no longer use the depreciation tables (which is how most software will determine depreciation).  Please see the following reference from IRS Pub 946 for additional information:  Basis adjustment due to casualty loss.

However, in your case, your basis (provided you are not taking a deduction for what you paid your contractors, and you do not claim net casualty loss of 2,000), is "returned" back to its original amount, which will allow you to continue to depreciate the property "on schedule".  However, if you do claim the contractors payments as expenses (theoretically), then the basis for depreciation would also be re-calculated, and that gets complicated because you can no longer use the automatic depreciation calculations provided by software.  This balances out over the life of the property.

@Carl can probably provide additional details.

@investor85

[M-MTax]

I think that the basis should remain unaffected as per Rev Rul 71-161

https://www.irs.gov/pub/irs-utl/am2006006.pdf
Casualty Loss Hurricane Sandy

Yes I would say you have a wash here because you're reducing basis by the amount of insurance funds you got and then increasing basis by the amount spent on restoring the property to its original state.....it's a wash except for the $2k you're out from the deductible.

[Carl]

@DanielV01 TurboTax does not make it easy by any stretch of the imagination. Plus, if you have to figure things manually then you can forget about e-filing with TurboTax. What one could do is just leave well enough alone with existing assets. But for the $2000 deductible out of pocket paid, enter it as another asset so as to account for the "addition" to the cost basis not cancelled out (per-se) by the insurance payout.

Technically, the insurance payout is reportable income. (Doesn't mean it's taxable). But that reportable income is basically "offset" by the loss. So it's a wash in the long run.

Now there is a way to "make it work" in TurboTax where you claim the loss and claim the insurance payout. But the bottom line end result would be "about" the same. As for the $2K out of pocket in this case, on a property with a cost basis of $210,000 that's only a 0.9% addition to the cost basis. Not worth the effort in my opinion - and we all know what opinions are like.

One thing to keep in mind though, is that if you get a tax reporting document from the insurance company for the payout, then you don't really have a choice and have to include it on your tax return. While it can be done with TurboTax, it's an absolute cluster**** to make it work so one can still e-file.

[investor85]

@DanielV01 @M-MTax I have read Pub 946. However, I was unable to get an answer for my scenario.

Here is my view based on the Rev Rul 71-161
https://www.irs.gov/pub/irs-utl/am2006006.pdf

The casualty loss is the FMV reduction which I will base on the cost of repairs = 16k.
The net casualty loss for me is 2k, my insurance deductible.

Even with this casualty loss claimed, the basis is reduced by FMV reduction = 16k. Any amounts spent (reimbursed from insurance or not, casualty loss or otherwise) on restoring the property to its original condition must be added back to the basis of property.

This example also addresses the partial insurance reimbursement scenario where the basis remains unaffected.

Question: Why is the 2k spent out of pocket and claimed as net casualty loss not added back to the property basis? (It is just the cost of restoration)
@Carl Would appreciate your input.

[Carl]

The net casualty loss for me is 2k, my insurance deductible.

How do you figure? You didn't lose that $2K. Not a single penny of it. You invested it into the property, thus increasing your cost basis in the property by $2K. You haven't "lost" a single penny.

[investor85]

@Carl The "casualty loss" and "repairs made for restoration" are two different things as per IRS.

My total loss is the FMV reduction which is 16k. This is regardless if my insurance reimburses me a penny.
This is a "loss" to me regardless of whether I make repairs or not. In my case, insurance paid me 14k reducing my net casualty loss deduction to 2k. However, the reduction to the basis is 16k (insurance + deductible).

^^ The above is very clear to me based on Pub 547, 551 and 946

If I chose to do repairs then the restoration must be capitalized, regardless of insurance reimbursement. The only question is, does the restoration go back to the basis or is it a separate depreciable asset.

I feel any restoration should be added back to the basis.

Please refer to example here which leaves the basis untouched. Rev Rul 71 -161

Adjusted basis before casualty loss____________________  $25,000x

 Less:

      (1) Allowable casualty loss deduction_____ $4,300x

      (2) Insurance or other compensation

            received or recoverable in the

            year the casualty loss was

            sustained___________________________    700x    
                                                                                                              5,000x

 Adjusted basis after casualty__________________________   20,000x

 Plus:

      (1) Debris removal expenditures___________  1,000x

      (2) Expenditures for repairs______________     4,000x  

                                                                                                         5,000x

                                                 -------  --------

 Adjusted basis after restoration of the property_______   25,000x

[DanielV01]

@investor85:  The issue with the example you cite above is that that is the calculation for nonbusiness property. The reason why?  With nonbusiness property, you cannot get a deduction for any expenses related to restoring a property; they add back to the basis to bring the property back to it's original value.  And, I think @Carl would agree that the IRS' explanation of how the basis is reduced is convoluted.  If you see the math in the example, the initial reduction of basis due to the casualty is the full amount of FMV loss on the casualty:  the part that insurance reimbursed, and then the portion that was just "loss".  But the IRS' explanation just helps define how they calculate the reduction.  You must reduce the basis by $4300 in insurance reimbursement because you "sold" this portion of property (for lack of a better expression).  Since this "sale" (to insurance) is a return of capital on the initial value of the property, it's not taxable money, but when you spend that money to restore the value of the home, you in essence buy the basis back.  (And the same applies to the "casualty loss" portion:  when you claim that on the tax return, you have "cashed in"  on its value and thus it reduces the basis, which paying for the restoration restores).

But when you are dealing with property for business use the situation changes completely, because of required depreciation (which, by the way, also reduces the basis on the property, which is why this gets complex).  So, using the example above you give, when the property is put into business use, it had a depreciable value of $25,000.  Let's say, just for argument's sake, that the property has depreciated for two years and you have already claimed $5000 of depreciation in those two years.  (The real numbers would be different, but it's easier to see with square numbers).  Then, in year three, the casualty loss occurs.  Because this is a business use property, you can choose to deduct the repair expenses (which are not capitalized, by the way. Repairs that restore a property's value are deductions.  Improvements and renovations which add to the value of the property are capitalized).

So let's say you decide to do that.  The insurance has reimbursed the casualty loss, so you don't claim the loss, and the insurance is not income (because it is being used by the loss).  The remaining portion of the loss is covered by claiming the expense you paid, so you wouldn't claim casualty loss.  But because you are claiming the expenses, this is where the complicated depreciation begins.  As stated above, depreciation also reduces basis.  So, if your original basis was 25,000, and you've taken 5,000 at the time of the casualty, the property's depreciation basis also drops to $20,000.  And now you have to synchronize this new depreciation basis with the current depreciation schedule.  You do not simply "start over".  Rather, your third year depreciation will be calculated as having a basis of $20,000, with $15,000 of remaining depreciable basis.  Which is why the IRS says you then have to go to the depreciation tables to find out what the percentage of depreciation is on the $20,000, and then subtract from the $15,000 to determine what basis is remaining in year 4.

As Carl pointed out, TurboTax doesn't handle this well (and I don't know of any software that does, frankly).  So for your situation, the easiest thing to do is to not claim any of it.  Do not claim the expenses, do not claim the insurance reimbursement, and do not claim the uncovered casualty loss.  It's not worth the trouble to recalculate your depreciation for such a small amount when it will work itself out in the end.  Either through depreciation you will eventually use all of this value on your returns, or at the time you sell the property you will have a higher basis (in effect), which will reduce your capital gains (and depreciation recapture); either way, the net result of what ends up getting claimed to the IRS is the same, which is what they are most concerned with.  And if this were audited, you have a defendable position.

[investor85]

@DanielV01 @Carl I think we agree that FMV reduction due to casualty is reduced from the basis for business property.

However, I disagree that costs to repair a business property due to a casualty loss can be deducted as an expense. As per IRS Reg. 1.263(a)-3(k)(1)(iii), the cost of replacing or repairing business property destroyed or damaged due to a casualty event ordinarily must be depreciated as an improvement - a restoration.

Under the IRS repair regulations that took effect in 2014, a building owner is only required to depreciate restoration costs to the extent of the property's adjusted basis immediately before the casually event that damaged or destroyed the building. Any costs over this may be currently deducted if they constitute repairs under the IRS repair regulations. (IRS Reg. 1.263(a)-3(k)(4)(ii))

Also, please refer to specific business property examples,

Example 3. Restoration after casualty loss

B owns an office building that it uses in its trade or business. A storm damages the office building at a time when the building has an adjusted basis of $500,000. B deducts under section 165 a casualty loss in the amount of $50,000, and properly reduces its basis in the office building to $450,000. B hires a contractor to repair the damage to the building, including the repair of the building roof and the removal of debris from the building premises. B pays the contractor $50,000 for the work. Under paragraph (k)(1)(iii) of this section, B must treat the $50,000 amount paid to the contractor as a restoration of the building structure because B properly adjusted its basis in that amount as a result of a casualty loss under section 165, and the amount does not exceed the limit in paragraph (k)(4) of this section. Therefore, B must treat the amount paid as an improvement to the building unit of property and, under paragraph (d)(2) of this section, must capitalize the amount paid.

Example 4. Restoration after casualty event

Assume the same facts as in Example 3, except that B receives insurance proceeds of $50,000 after the casualty to compensate for its loss. B cannot deduct a casualty loss under section 165 because its loss was compensated by insurance. However, B properly reduces its basis in the property by the amount of the insurance proceeds. Under paragraph (k)(1)(iii) of this section, B must treat the $50,000 amount paid to the contractor as a restoration of the building structure because B has properly taken a basis adjustment relating to a casualty event described in section 165, and the amount does not exceed the limit in paragraph (k)(4) of this section. Therefore, B must treat the amount paid as an improvement to the building unit of property and, under paragraph (d)(2) of this section, must capitalize the amount paid.

Now that it is clear that restoration due to casualty must be capitalized (to the extent of the basis before casualty) for business property, the only question is does it go back to the basis or a new asset should be created.  I believe, it should be added back to the basis. (In my case, adding the cost of restoration back to the basis does not exceed the basis before casualty.)

If you disagree, can you please share relevant law, case law and examples?

[DanielV01]

@investor85.  I don't disagree with your position, with a caveat, which I'll get to.  And I could be wrong in what I present, but here's the point:  the position you take must be defendable before the IRS.  I will concede the point that the expenses in this scenario must be capitalized with the 

Probably more "technically correct" under this situation is treat the expenses as a "separate" depreciation element, This would be consistent with how the IRS normally would treat a capitalized improvement.  

But for you, this leads to some complicated calculations, because you have three separate elements:  you would have to re-calculate your original depreciation (see my example in my prior answer, which still applies), you would have a deduction of $2,000 for casualty loss (which lowers the FMV of the house by $2000), and then a restoration valuing $14,000 (the reimbursed portion of the casualty by the insurance for which you must capitalize the expense).  With whatever remaining depreciation you have left on the property, you will now have two separate depreciations:  The adjusted depreciation schedule-$16000 (the full reduction of original basis, which now means that you that you are recalculating the original house basis manually on $194,000 instead of $210,000); and a new $16,000 restoration depreciation which is depreciated over 27.5 years.  All of this is to claim $2000 of loss expense this year, and the $2000 of loss is "reinvested" back into the basis (as part of the $16,000 depreciation element.  In this scenario, you are "cashing in"  on $2000 of unreimbursed loss, and then reinvesting that back into the building out of pocket, so that must be capitalized.

As described above, your situation is actually a mix of Example 3 and Example 4, because you have a partial insurance reimbursement.

Maybe @Carl sees something I don't, but for the amount of adjustments you need to make to get this technically correct, it's more trouble than it's worth.  You will notice in your example that the phrase "properly reduced the basis".  This gives rise to a gray area:  what if the basis is not "properly" reduced.  In that situation the basis remains the same, and you simply continue depreciating the original value of your basis, without claiming any of the casualty loss.  If the depreciation is fully taken over the life of the property, the end result of how much of the value of the property was used  via depreciation would be the exact same.  All of the adjustments in paragraph 2 amount to 210,000, and your original basis is 210,000.  If the IRS were to quibble with the calculations, it would come up on the sale of the property due to depreciation recapture.  At the time of sale, you would need to pay tax on the larger of:

• Depreciation taken
• Depreciation allowable

Doing the math in my head, maintaining this as a simple equation (keep depreciating "as-is") will result in taking more depreciation, but not a huge amount more, than what is technically allowable.  In all likelihood, they will be just fine with this because they will get the taxes back when you sell the house.  Only in the case where depreciation taken is less than depreciation allowable would there be a depreciation recapture issue.

I can't cite tax case law of a specific decision regarding this, so in the end it's your decision.  But I believe you to have a defendable position with very little risk by not reporting all the movement by reducing the basis.  

And if you want to do this, and are unsure on the tax legality, you can use Form 8275 and cite the tax regulation you researched to disclose your position on leaving the basis "as-is".  

[investor85]

@DanielV01 Thank you for accepting that these repairs must be capitalized. Thank you for sharing your views. I really appreciate all the input here. I also understand that I should take a position that is defendable during IRS audit.

However, I think we are over-complicating it by creating separate assets for restoration property.

Probably more "technically correct" under this situation is treat the expenses as a "separate" depreciation element, This would be consistent with how the IRS normally would treat a capitalized improvement.  
>> While I do agree that improvements must be capitalized, I think a "separate" depreciation is not needed.

I support my position based on the following excerpt from Rev-Rul 71-161 that talks about business property casualty damage
2. The published position of the Service.
Rev. Rul. 71-161, 1971-1 C.B. 76, specifically applies these principles to the case of property damaged by a casualty. In that revenue ruling, the taxpayer sustained business property damage as a result of a hurricane and paid for the removal of debris and repair of the damaged property. The debris and damage to the property resulted in a decrease in the fair market value of the property immediately after the casualty. The cost of the debris removal and property repair was used as evidence of the amount of the casualty loss sustained. The revenue ruling holds that the debris removal and repair costs themselves are “in the nature of replacement of the part of the property that was damaged.” Id. at 77. Accordingly, the costs are capitalized and added to the property’s basis pursuant to § 1016(a)(1).

This means that restoration that covers any reduction in the basis due to casualty should be added back to the basis. Hence,  in my case, the basis would remain unchanged. If the basis remains unchanged, then we may continue to depreciate the asset as before in TurboTax.

cc: @Carl 

[Carl]

This means that restoration that covers any reduction in the basis due to casualty should be added back to the basis. Hence, in my case, the basis would remain unchanged. If the basis remains unchanged, then we may continue to depreciate the asset as before in TurboTax.

That's the route I'm suggesting. Especially since changing the basis of any existing asset in the TurboTax program will completely screw things up in the depreciation history, as well as the future depreciation calculations.

If you just add another asset for the $2K out of pocket, that will actually "add" $2K to your cost basis. But then, we're only talking a mere 0.9% increase in cost basis. So I wouldn't even bother with that. But that's me.

[investor85]

@Carl We are both suggesting the same thing, but our reasons behind it seem to be different.

In my view, $2k is already accounted for in the unchanged basis. Basis is reduced by 16k (total FMV reduction) and then increased by 16k (total restoration). So net change to basis is $0. No new asset is added. I hold this to be correct adjustment to the basis and it will not screw things up in the depreciation history, as well as the future depreciation calculations.

In your view, the $2k should be added as another asset which results in changing the cost basis of damaged asset somehow and affects depreciation calculations but for simplicity you are suggesting that this change be omitted. 

I am sorry but I have not yet understood the "technically correct" calculation that you seem to follow. If you don't mind can you elaborate more on it.