Repair Rules Could Cut Tax Recoveries from Sandy

A casualty-loss rule blocks corporate efforts to recover benefits in the wake of the superstorm.
Kathy HoffelderNovember 27, 2012

A complication in claiming a casualty loss from superstorm Sandy could leave commercial property owners in worse financial shape than before, thanks to a wrinkle in the tax code involving repairs. The casualty-loss rule in new temporary repair regulations put in place by the Treasury Dept. last December could make it harder to recoup property losses.

The rule, Temporary Treasury Regulation 1.263(a)-3T, was created to define when a company must capitalize a repair cost — that is, record it in the balance sheet where its cost can be depreciated, rather than the income statement — and when one can deduct it.

Although the regulation is “temporary,” it is enforceable. Under the rule, a taxpayer cannot deduct the cost of a repair to damaged property if the taxpayer takes a deduction for a casualty loss related to the property. (Casualty losses are tax losses stemming from a sudden, unexpected, or unusual event. In contrast, ongoing property deterioration via a steadily continuing cause wouldn’t be a casualty loss.)

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That’s a hefty change from prior years. Previously, a taxpayer was able to potentially claim both a casualty-loss deduction for property damaged and a repair deduction for expenditures to correct the results of the casualty event, says Susan Grais, executive director of business tax services at Ernst & Young. “This bright-line rule generally has been viewed as an unfavorable change from prior law.”

Small and midsize entities are more likely to be hurt by the new rules. Too often companies mistakenly deduct a casualty loss without considering the tax consequences, according to Dwight Mersereau, a partner at law firm McDermott, Will, and Emery. CFOs and tax directors need to understand they have a few choices when it comes to repair regulations, he notes. For one, they can decide to deduct the casualty loss and capitalize the cost of repair as if new property were built. Alternatively, in certain circumstances, they could forgo the casualty loss and deduct the repair, he says.

Another out for a firm is to simply deduct the casualty loss and deduct the repair — but it would be challenging the regulation. That might not be such a bad thing, however, adds Mersereau. “Taxpayers have recently challenged regulations and have won. So that’s an option.”

Whatever direction CFOs and tax directors may go when looking at casualty losses on behalf of their corporations, they should remain consistent in what they report from year to year regarding the disposal of property, according to Nathan Clark, senior director for tax accounting methods at BDO, an accounting and consulting firm. “This year could be influenced by what you did in prior years,” he says.

Making the wrong decision could mean stiff consequences for corporate taxpayers. “The repair regulations could actually penalize a corporate taxpayer [that] claims a casualty loss,” says Elan Keller, member of Caplin and Drysdale’s New York law office.

If commercial taxpayers claim a casualty loss from a storm like Sandy, “they would need to capitalize such loss over the original recovery period of the destroyed property, which could produce an inequitable result,” notes Keller.

Why is that the case? The casualty-loss provisions of the repair rules are at odds with the general casualty-loss deduction rules followed by the Internal Revenue Service, notes Keller: a situation that can spawn a trap for unwary corporate taxpayers. “CFOs and tax directors should carefully consider and plan for the tax consequences of claiming a casualty loss on their tax returns,” he says.

If a utility company, for example, had a wooden pole knocked over during a storm, the company should, in theory, be able to repair it and not capitalize it unless the company replaced that pole with a much sturdier cement pole likely to last a whole lot longer.

“They should be able to recover the casualty that Congress intended. And then, if the company is repairing it and not improving it, they should get that deduction as well,” says Mersereau. Taxpayers see the rule change “as bad tax policy. You shouldn’t have to automatically capitalize the cost after the casualty.”

For its part, the IRS is aware of the problems the new rules are causing corporate taxpayers. It received several comment letters from corporate taxpayers and plans to issue final regulations in 2013.

Several changes are likely to occur in the final rules, including more relief for small businesses and more clarification over the sale of an asset or property. But despite such revisions, key differences would remain between what corporate taxpayers may want and what Congress and the IRS have in mind.

After all, Congress intended for companies to get that deduction if a casualty hits one’s property as well as a deduction for property damage, notes Mersereau. But the Treasury Dept. says in the regulations that the casualty event should give rise to one deduction and not two.

“In some industries it’s a large issue,” adds Mersereau, because taxpayers generally believe you should get both deductions, not one or the other.

Last week the IRS made some headway in alleviating the decision-making process for corporations. It extended the effective date of the repair regulations from 2012 until 2014, while permitting taxpayers to comply as early as 2012. As BDO’s Clark explains, “this gives clients the option to implement favorable method changes now and also delay until 2014 unfavorable method changes.”

Still, most corporate taxpayers are hoping Washington provides more relief when it comes to claiming a casualty loss. “I would not be surprised if at some point Congress, the IRS, or Treasury addresses the casualty-loss provisions of the repair regulations to allow for more meaningful economic relief for corporate taxpayers who suffer catastrophic losses as a result of an event like Hurricane Sandy,” says Keller.

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