A casualty loss may occur as a result of a flood, hurricane, tornado, mudslide or other natural disaster. The intuitive thought pattern is: “My apartment complex worth $5,000,000 suffered major damage totaling $1,500,000 for repairs and rent loss. Fortunately, I was completely covered for both physical damage and rent loss, other than a small deductible. There is clearly no casualty loss I can claim as a tax deduction, right?”
Tax deductions are the basis for tax reduction. Tax deductions reduce taxable income but do not directly reduce federal income taxes. For example, $100,000 of tax deductions reduces federal income taxes by $35,000 ($100,000 X 35%), assuming a 35% tax rate. Most tax deductions require a cash expenditure (labor, material, supplies, utilities, etc). A current period cash expenditure is not required for some real estate tax deductions and may not be required for a casualty loss.
Most real estate owners and investors do not consider casualty losses as a source of tax deductions. Few investors claim the casualty loss tax deduction the federal income tax code allows them. Let’s review the criteria for a casualty loss tax deduction and the thought process regarding acquisition of a property that has suffered a casualty.
Real estate owners suffer a casualty loss when the market value immediately after the casualty plus insurance proceeds is less than the market value immediately before the casualty. The complex issue is how to value the property immediately after the casualty. Let’s consider a 1-story suburban office park in Mississippi which suffered 3-feet of flooding due to Hurricane Katrina. Let’s further assume: 1) 8 feet of sheet rock must be replaced in the entire property to rebuild, 2) although the property was 90% occupied before the flood, occupancy is expected to only be 5% while rebuilding occurs, 3) stabilized occupancy after renovation is not clear since some businesses may not return, 4) construction will take 12-18 months due to the labor constraints and 5) the owner has casualty insurance to rebuild but did not have rent loss/business interruption insurance.
It is clear the market value after the casualty is less than the market value before the casualty less construction costs. Other factors to consider are: rent loss, market risk that not enough tenants will be available after construction is completed, cost of construction management, a illiquid market with few buyers just after the casualty, construction risk, interest rate risk (rates could rise during the construction period negatively affecting value), risk that operating expenses could increase during the construction period (perhaps insurance) and compensation for entrepreneurial effort to induce a buyer to coordinate labor capital, management and compensation for capital during the reconstruction and releasing process.
A careful analysis by an appraiser might show the improvements have no value after the flood. In appraisal assignments performed by the writer, a casualty loss of 10-30% of the market value before the casualty has occurred (in a straight-forward, defensible analysis) is typical. This can generate a meaningful casualty loss (and tax deduction).
For example, a property with a market value of $5,000,000 suffers a 30% casualty loss. While the casualty is a serious hardship for the owners, the $1,500,000 ($5,000,000 X 30%) tax deduction will mitigate the financial loss.
Congress provided a casualty loss tax deduction to encourage investment in real estate. If you have the misfortune to suffer a casualty loss, take the helping hand offered by congress and take the tax deduction.
Cost segregation produces tax deductions and reduces federal income taxes across the country and in every size market. Below are just a few examples of cities where cost segregation generates meaningful tax deductions.
San Francisco, CA
New Orleans, LA
New York, NY
Las Vegas, NV
Los Angeles, CA
Salt Lake City, UT
Ft. Lauderdale, FL
San Antonio, TX
Little Rock, AR
Kansas City, MO
San Jose, CA
Palm Bay, FL
Cost segregation produces tax deductions for virtually all property types, including the following:
Auto service garage
Almost every industry, including the following, can generate cost-efficient tax deductions by using cost segregation.
Nondurable good wholesalers
Durable good wholesalers
Day care facilities
Computer and electronic manufacturing
Health care facilities
Warehousing and storage
Electronic and appliance stores
The appraisal division of O’Connor & Associates is a national provider of commercial real estate appraisal services including insurance valuation, real estate appraisals, cost segregation studies, due diligence, feasibility studies, financial modeling, gift tax valuations, highest and best use analyses, casualty loss valuations and HUD map market studies.