Business Casualty and Theft Losses
The treatment of casualty gains and losses differs depending on whether the property is personal-use, business, or investment property. In Chapter 5, Standard and Itemized Deductions, the deduction of personal casualty losses as itemized deductions was discussed.
Gains and losses arising from a casualty or theft of property used in a trade or business or held for investment are treated differently from gains and losses arising from a casualty or theft of personal-use property. Business and investment property must be identified as a capital asset, trade or business property subject to an allowance for depreciation, or ordinary income property. The following rules apply to the treatment of business or investment property:
Property held for one year or less. Gains from trade or business property (including property used in the production of rental or royalty income) and gains from investment property are netted against losses from trade or business property and the resulting net gain or loss is treated as ordinary income or loss. Losses from investment property are separately considered.
Property held over one year. Gains and losses from trade or business property and investment property are netted. If the result is a net gain, the net gain is included in the calculation of the net section 1231 gain or loss (the gains and losses are treated as section 1231 gains and losses). If the result is a net loss, the gains and losses from business and investment property are excluded from section 1231 treatment. The tax treatment of the gains and losses depends on whether the property was used in the taxpayer’s trade or business or held for investment. Gains and losses from business use assets are treated as ordinary income and ordinary losses, respectively.
If the taxpayer recognizes a gain as a result of a casualty and the property involved is depreciable property, the depreciation recapture requirement may cause all or a part of the gain to be treated as ordinary income. A casualty involving business property is included in the definition of an involuntary conversion so that gain realized may be eligible for deferral under the special involuntary conversion provisions discussed earlier in this chapter.
Example
Stan had two pieces of business equipment destroyed by a tornado. One item had an adjusted basis of $25,000 ($91,000 original basis less $66,000 accumulated depreciation) and a FMV of $20,000 on the day of the tornado. The other item had an adjusted basis of $24,000 ($35,000 original basis less $11,000 of accumulated depreciation) and a FMV of $30,000. Stan receives $20,000 from his insurance company for the loss of the first item and $26,000 for the second item. Stan’s casualty gain or loss follows:
| Item 1 | Item 2 | |
|---|---|---|
| Insurance proceeds | $20,000 | $26,000 |
| Basis of property | 25,000 | 24,000 |
| Gain (loss) | $(5,000) | $2,000 |
The netting of business casualty gains and losses results in a net loss: thus, the gains and losses are excluded from section 1231 treatment. Since the loss on Item 1 was a loss from an asset used in the taxpayer’s business (not an asset held for investment), the loss is an ordinary loss. The $2,000 gain on Item 2 is ordinary income, section 1245 recapture.
Problem
A computer used by Leo in his real estate business was completely destroyed by fire. The adjusted basis of the machine was $2,500 (original basis of $3,850 less accumulated depreciation of $1,350). The computer was not insured. Calculate the amount and nature of Leo’s gain or loss as a result of this casualty. $__________ Nature:__________
