Owners of commercial property damaged by Hurricane Harvey can reap large federal tax deductions, even if they are fully insured.
How is this possible?
It is simple; the law for calculating a casualty loss deduction includes deducting the value after the casualty from the value before the casualty.
The value of the property after the casualty is much less than the value before the loss less the physical damages. This is clear once you think about it a bit. If you were offered the opportunity to purchase a commercial property that flooded with one feet of water, what factors would you consider?
There are risks for construction costs, releasing, lost rents, and the requirement to report the property flooded to a subsequent purchaser. In addition to these factors, someone purchasing a flooded property is going to want to be compensated for the effort of coordinating the real estate, finance, construction and leasing.
Depending on the severity of the casualty, the loss (other than construction costs) would typically be 10 to 30 percent of the value of the property prior to the flood. For a property worth $2,000,000, that would translate to a deduction of $200,000 to $600,000. The federal tax savings at 45% would be $90,000 to $270,000. This is legal even though you did not make a payment and the property does not suffer from a reduction in value over the long term.
Not convinced of the tax savings?
Back to the Basics
Tax reduction results from tax deductions. 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 $45,000 ($100,000 X 45%), assuming a 45% tax rate. Most tax reduction require a cash expenditure (labor, material, supplies, utilities, etc). A current period cash expenditure is not required for some real estate tax deductions and is not be required for a casualty loss.
You Can Claim a Loss without any Expense!
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 which will generate tax reduction, right?”
Most real estate owners and investors believe the above statement to be true. Few investors claim the casualty loss tax reduction the federal income tax code allows them.
Let’s next review the criteria for a casualty loss tax deduction and the thought process regarding acquisition of a property that has suffered a casualty.
Basis for Property Casualty Loss Deduction Even if Insured
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 2-story suburban office park in Houston, Texas which suffered 3-feet of flooding due to Hurricane Harvey.
Let’s further assume:
- 1) 4 feet of sheet rock must be replaced in the entire property,
- 2) although the property was 90% occupied before the flood, occupancy is expected to only be 40% while rebuilding occurs,
- 3) stabilized occupancy after renovation is not clear since some businesses may not return and office occupancy in Houston is about 80%,
- 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.
Factors to Consider
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, an 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 endure the previously mentioned risks.
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 is typical. The analysis is straight-forward and defensible. This can generate a meaningful casualty loss tax deduction which results in tax reduction, even though there is no cash disbursement or long-term diminution in value.
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. Based upon a 45% tax rate, the tax reduction is $675,000.
I’m From the Government, and I’m Here to Help, Really
Congress provided a property casualty loss tax deduction to encourage investment in real estate. If you have the misfortune to suffer a property casualty loss, take the helping hand offered by congress and take the tax deduction.