No Casualty Loss Deduction for Stigmatization Resulting from Flood Damage

(Parker Tax Publishing September 2019)

The Tax Court held that a taxpayer was not entitled to a casualty loss deduction under Code Sec. 165 for damage the taxpayer's home sustained as the result of a hurricane. The court noted that physical damage to property is a prerequisite to deducting a casualty loss and the appraisal of the taxpayer's property after the hurricane relied heavily on the decline in value resulting from the stigmatization of the property due to a flooded basement and deductions on the basis of a temporary decline in market value are not permitted. Taylor v. Comm'r, T.C. Memo. 2019-102.

Background

In 1998, Robert Taylor bought a home in the River Oaks neighborhood of Houston, Texas. Taylor paid $9,250,000 for the property and bought it in an as-is, unwarranted condition. The property included a house, a three-car garage, a cabana, a guardhouse, and a 635-square-foot basement wine cellar in which Taylor stored 6,889 bottles of wine and computer equipment with customized wine database software. Taylor listed the property for sale in 2007 for $18.5 million.

On September 13, 2008, Taylor's property sustained significant damage in Hurricane Ike, a category 2 hurricane. The property incurred tree and fence damage, broken windows, and water damage inside the house. The basement wine cellar was flooded two to three feet deep and mold formed because of the standing water. In addition, the ducts and pipes in the basement, which were wrapped in asbestos, began to deteriorate in the flood water. Taylor spent several months repairing the property. The 6,889 bottles of wine were cleaned in a specialized decontamination process to preserve the labels, the wine quality, and their respective wooden crates. After the wine was removed, the basement was remediated for asbestos and mold.

Taylor filed an insurance claim for the hurricane damage. A salvage agent determined that the wine was a total loss, but Taylor kept 21 bottles. Overall, Taylor received a total of $2,386,293 in insurance proceeds, including $1,573,947 for the value of the wine. Taylor took the property off the market for the remainder of 2009 in order to make all needed repairs. He eventually sold it in 2014 as unimproved property for $12 million.

On his tax return for 2008, Taylor claimed a casualty loss deduction of $888,445. Taylor's return included a Form 4684, Casualties and Thefts, on which he reported a basis in the property of $6.5 million, insurance reimbursements of $2,303,614, a fair market value before the casualty of $15,442,059, and a fair market value after the casualty of $12,250,000. The pre-casualty fair market value was based on the 2009 listing price, adjusted for the time the property spent on the market. No explanation of the post-casualty fair market value was provided. The return was prepared by an accounting firm and reviewed by a CPA. In a 2012 notice of deficiency, the IRS determined that Taylor was not entitled to a casualty loss deduction and applied an accuracy-related penalty of $80,735 for an underpayment due to negligence or a substantial understatement. Taylor challenged the notice in the Tax Court.

In 2016, Taylor supplemented his Tax Court petition with a retrospective appraisal prepared by Gayle Woodum, a licensed real estate appraiser. Woodum determined that the property's fair market value was $18,468,000 before the hurricane and $11,081,000 after it. Woodum's post-casualty valuation consisted of $10,650,400 for the land and $430,600 for the house and other improvements, representing a 40 percent decline in total fair market value but a 95 percent decline in value to the house and other improvements. At trial Woodum further opined that the property was "stigmatized" as a result of the flood and said that part of the stigmatization was attributable to the discovery of asbestos during the post-flood remediation process.

Casualty Loss Deductions

Before 2018 and after 2025, Code Sec. 165 allows a deduction for any loss of property sustained during the tax year and not compensated for by insurance or otherwise that arises from fire, storm, or other casualty. Code Sec. 165(h)(5) provides that during 2018-2025, personal casualty loss deductions are limited to losses attributable to a federally declared disaster. Reg. Sec. 1.165-7(a)(2) specifies two alternative methods for computing a casualty loss deduction with respect to years in which such losses are allowed. The taxpayer must either provide a competent appraisal establishing the property's fair market value before and after the casualty or, if the taxpayer has repaired the property, the taxpayer may use the cost of repairs to prove the loss of value from the casualty. Under Reg. Sec. 1.165-7(b)(1), the casualty loss deduction is limited to the taxpayer's basis in the property. Reg. Sec. 1.165-7(b)(3) requires the taxpayer to reduce the amount of the deduction by any compensation received for the loss.

Analysis

The Tax Court denied Taylor's casualty loss deduction because it found that he failed to establish the loss under either method provided in Reg. Sec. 1.165-7(a)(2). In the court's view, Taylor did not establish that the valuations reported on his 2008 Form 4684 were based on competent appraisals. The court also found that Woodum's retrospective appraisal was not a reliable measure of Taylor's loss because her post-casualty valuation relied heavily on the stigmatization of the property due to the flooded basement. The court explained that physical damage to property is a prerequisite to deducting a casualty loss and that deductions are not allowed on the basis of a temporary decline in market value. The court cited previous decisions in which it denied deductions for purported immediate buyer resistance to purchases in a flood damaged area in the absence of post-flood sales of comparable properties. The court noted that Woodum did not include any post-hurricane sales of comparable properties in her analysis.

The court also noted that Woodum factored in the stigmatization of the property due to the discovery of asbestos in the basement. The court found that a casualty event occurs as a result of an unexpected, accidental force, and noted that, while asbestos was discovered when the basement flooded, Taylor bought the property in an as-is, unwarranted condition and the asbestos was present when he bought it. According to the court, any diminution in value attributable to the discovery of the longstanding asbestos was not part of Taylor's casualty loss.

Addressing Taylor's costs of repairs, the court noted as an initial matter that Taylor failed to establish his basis in the wine collection or computer equipment. The court said that where a taxpayer's basis is not established, his or her loss cannot be computed. Although Taylor generally would be entitled to a casualty loss deduction equal to the cost of the repairs in excess of his basis, the court found that Taylor did not argue that he made repairs to the property that were not compensated by insurance. The court further noted that Taylor bought the property in 1998 for $9,250,000, but reported the basis on his Form 43684 as $6.5 million and did not provide an explanation of the difference. The court also found that Taylor's insurance payments were well in excess of the cost of repairs he would otherwise be entitled to deduct as a casualty loss.

The Tax Court did not uphold the imposition of penalties because it found that by relying on his CPA and the accounting firm to prepare his 2008 return, Taylor acted in good faith and with reasonable cause.

For a discussion of determining the amount of a casualty loss, see Parker Tax ¶84,530.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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