Rules for deducting casualty losses

Special to's tax-advice column features three experts from the Hunt Valley accounting firm SC&H Group answering questions about preparing your return every Monday until April 17. To be included in the following weeks, please use the form at the right side of this page to submit your questions.

Bernie Weill, Brooklyn, N.Y.: Can I deduct losses on my house destroyed by a fire during 2005, although I have not yet settled with the insurance company as of Dec. 31, 2005?

SC&H Group: Generally, you can deduct a casualty loss only in the tax year in which the casualty occurred. To determine your deduction for a casualty or theft loss, you must first figure your loss.

When calculating your loss on personal-use property, you must subtract the actual or expected insurance reimbursement. You must reduce your loss even if you do not receive payment until a later tax year. Furthermore, if you later receive more or less reimbursement than you expected, you may have to include that difference on your return for the year in which you can reasonably expect no more reimbursement.

Finally, after you have figured your casualty loss on personal-use property, your deduction will be subject to two limitation rules: the $100 rule and the 10 percent rule. The $100 rule, simply stated, says you must reduce each casualty loss by $100 when figuring your deduction. The 10 percent rule applies after you apply the $100 rule and states you must reduce your total casualty loss by 10 percent of your adjusted gross income. If you determine you have a loss, use both of the following forms to report the loss: Form 4684 and Schedule A (Form 1040). (See IRS Publication 547 for more information and examples.)

Charles Brough, Manchester: I have a reverse mortgage. I paid over $7,000 in interest on my reverse mortgage last year. Is it deductible?

SC&H Group: A reverse mortgage is an interest-only loan that capitalizes the interest expense along with the principal during the life of the loan. That means that there are no loan interest payments at all until the note comes due. Since this type of mortgage draws from the principal in the property, the amount received is tax free.

Generally, you can only deduct interest you actually pay on a loan secured by your home. However, in the case of a reverse mortgage, since the interest is added to the loan balance over the term of the loan, it is not deductible under the personal residence interest rules until the loan is actually repaid.

Sharon, Bel Air: My 80-year-old mother lives with my husband and me. Can we claim her as a dependent? She has Social Security income, as well as approximately $1,280 in pension yearly. She does not qualify to file taxes. We take care of her in the sense that we provide shelter, food, take her to appointments, etc.

SC&H Group: You are allowed to claim an individual as a dependent if they satisfy all of the following tests.

  • Citizenship test: The dependent must be a U.S. citizen, resident or national, or a resident of Canada or Mexico.
  • Joint return test: No exemption may be claimed for a dependent who files a joint return (except if only to claim a refund and no tax liability exists).
  • Relationship test: Is a qualifying relative (such as a mother, father, etc.)
  • Support test: You provide over 50 percent of total support, or two or more persons shared the support and together provide more than 50 percent of total support. Examples of items that qualify as support are food, lodging, clothing education, medical, dental, recreation, transportation and other necessities. Examples of items that do not qualify as support include life insurance premiums, taxes paid on their behalf, the value of personal services performed for the dependent and funeral expenses.
  • Gross Income test: Your mother has less than $3,200 of gross income in 2005. Gross income does not include tax-exempt income (certain Social Security benefits, municipal bond interest, etc.), but does include income from rental property or from a Schedule C business. Your mother does not have to live with you, so long as the gross income and support test are met. Based on the facts you presented, your mother would be able to be claimed as a dependent in 2005. Dean Scannell, Perry Hall: Can you still take a deduction on interest paid on student loans? SC&H Group: You are allowed to deduct, in 2005, up to $2,500 of interest paid on qualified education loans for you, your spouse, and/or a dependent's college and vocational school expenses. The deduction is an adjustment to income on Line 33 of the Form 1040. The deduction begins to be phased out when modified adjusted gross income is between $50,000 and $65,000 ($105,000 and $135,000 if married and filing joint). In order for the loans to be considered qualified education loans, the funds must be used for tuition, fees, room and board, books, equipment and transportation at an eligible institution and solely for that purpose. Lois, Cockeysville: I am doing my elderly father's taxes this year. He has a [Form] 1099 from his investment company, and on a summary page with the statement, it has a paragraph saying to list tax-exempt interest on the 1040, and it isn't included in your taxable income. But, it is included on the Social Security worksheet. It does not seem fair that an elderly person who has put money into tax-free investments for that very reason gets penalized for it. Since tax-exempt interest isn't listed on the 1099, do I have to show it? When a professional group did his return previously, they didn't show it. SC&H Group: Tax-exempt interest should be reported on Line 8b of your father's 1040. While the actual interest income is not considered part of his federal taxable income, it is included in the calculation of taxable Social Security benefits. Additionally, interest that is exempt from federal income tax is not always exempt from state taxes. If the information provided with the 1099 does not indicate the amount of interest that is exempt from state taxes, you may want to call the investment firm. Karen Deangelis, Baltimore: My fiancé earns a salary from the full-time fellowship program he is currently enrolled in, and [he] moonlights at another hospital, where he is paid by the hour. Is he eligible for any special work-related tax deductions? SC&H Group: There are no special tax deductions for having more than one job; however, your fiancé is certainly entitled to deductions for unreimbursed employee expenses such as union dues and educational expenses. Another issue that is common to individuals with more than one job is excess Social Security withholding. Herman, Denver: In 2005, I added a friend to my townhome title through a Quit Claim Deed for a few months until he gets his own mortgage and get[s] everything under his name. I moved to another house. To prove to the mortgage company in the future that he can handle the payment, he's been making the mortgage payment by sending it directly to the bank. I never see the money. Now, I got a [Form] 1098 from the bank for that mortgage and I'm confused. I called the IRS and some people from there say I can't use the interest paid as [a] deduction. Others say I have to count the money that my friend paid as income and then use the deduction. What do I need to do? SC&H Group: You cannot take a deduction for mortgage interest that you did not pay, even though you were issued a 1098 from the mortgage company. The Treasury regulations provide that the legal or equitable owner of real estate subject to a mortgage may deduct interest paid on the mortgage indebtedness, even though the owner is not personally liable on the indebtedness. By adding your friend to the title through a Quit Claim Deed, you have transferred [to him] an interest in the property. Since your friend now has an interest in the property and is making the actual mortgage payments, he is entitled to the deduction even though he is not liable on the indebtedness. However, you are entitled to deduct any mortgage interest that you paid during the year prior to this arrangement with your friend. These same rules would apply to the real estate taxes on the property. Rachel Kurtz, Sykesville: My ex-[husband] refuses to pay for items included in our custody agreement. Can I take the amounts (non-taxable items) as a bad debt? SC&H Group: In order for you to take a deduction for a bad debt, you need to have tax basis in it. In order to establish basis, you must have either included the amount in taxable income or loaned out the actual cash. Since neither of these has occurred, you would not be able to take the amounts as a bad debt deduction. Bruce Daeschner, Forest Hill: How do I calculate [alternative minimum tax] for company stock options I have sold? SC&H Group: We assume you mean you exercised stock options (versus sold them), and that they are incentive stock options. If this is correct, and if you are still holding the shares you received from the exercise (if you sold them within one year of exercise this answer will not apply), your alternative minimum tax adjustment is calculated by multiplying the number of shares received by the difference between the fair market value of the stock on the date of exercise and your strike price. This is entered on Form 6251, Line 13 of your 2005 tax return. Note that you now have a dual basis for this stock. The amount you paid for the stock is your regular tax basis, but your alternative minimum tax basis is higher and includes the alternative minimum tax adjustment. When you sell the stock, some or all of the alternative minimum tax you paid may be allowed as a credit against your regular tax liability. Jack, Baltimore: If you inherit a house through a gift deed which named multiple owners, how do you figure out the income tax for the beneficiaries? This was done to reserve a life estate. SC&H Group: Normally, if you inherit something, you will receive a step-up in basis to the fair market value of the asset on the date of death (assuming alternative valuation is not elected). In your case, you received the house as a gift, so the donor's basis carries over to you. If you later sell the house, this is the basis you use to calculate your gain, before adding to that starting point any improvements you made to the home with your own funds. Mike, Maryland: My mother passed away in 2004, and there was not enough estate to pay off all of her credit card bills. I've received two [Form] 1099s from credit card companies addressed to her estate. Do I need to file tax returns for 2005 on these 1099s? If so, is the estate liable for any potential taxes? SC&H Group: The estate will need to file a tax return if the 1099 income is more than $600 and it might need to pay tax on this income. According to Maryland law, if there are insufficient assets to pay all claims in full, payment is made in a designated order. Depending on the situation, there may not be enough assets to pay this tax after the other claims are paid. There are also certain exceptions to paying tax on debt forgiveness that may apply. The personal representative should consult with a professional to determine how Maryland estate law, as well as the income tax rules, apply to this particular situation. Brandon, Fort Meade: If you have to include your income tax refund from the previous year as part of your income when filing your state taxes, isn't that considered double taxation? SC&H Group: You are only required to include a state tax refund in income if in the previous year you claimed a deduction for it on Schedule A as an itemized deduction. If you claimed the standard deduction in the previous year, you do not have to include it. It is not considered double taxation because you used it to reduce your taxable income in the previous year. Charles Francis, Bel Air: Is there a tax deduction or credit available in the 2005 tax year for the homeowner who replaces heating and air conditioning systems with new, high-energy systems? SC&H Group: The Energy Policy Act goes into effect for the 2006 tax year. Individuals will be allowed a 10 percent credit for installing qualified energy efficiency improvements. Items such as insulation systems to reduce heat loss or gain, exterior windows and exterior doors are eligible, provided they meet certain requirements. You will also be allowed up to a $500 credit for qualified residential energy property. This $500 is composed of a $50 credit per advanced main air circulating fans, $150 per qualified natural gas, propane or oil furnace or hot water heater, and $300 for each item of qualified energy efficient property. In order to be eligible for this credit, all property must be placed in service after Dec. 31, 2005, and before Jan. 1, 2008. Denise Michaloski, Baltimore: I recently sold a home that was bought just to sell for profit. I completely renovated it before selling it (but only several months passed between buying and selling). How is money taxed that is profit? How is that calculated? Do closing costs, repairs and remodeling reduce the profit, and therefore reduce how much is taxed? SC&H Group: The gain will be treated as a short-term capital gain because you owned it for less than one year, and it was capital property held for investment. To calculate the gain, you must first calculate your basis in the property. Your initial basis is the price you paid for the house. The remodeling costs and closing costs would be added to your basis. The expenses for repairs and remodeling would also be added to the basis since the property was never placed in service. They essentially will reduce the profit you recognize, because by increasing the basis, your gain will be decreased. Your gain will be the selling price less your adjusted basis. This is reported on Schedule D, Part I of Form 1040. There could be additional tax issues if you are considered to be in the trade or business of renovating properties. Roberta Croney, Glen Burnie: My husband was granted executive stock options by his employer in 2003, not to be exercised until 2006. However, when he passed away in 2004, I was then required to exercise them within one year, which I did in January 2005. The stock was then immediately sold. How do I report this on my tax return, and does the fact that the options were inherited have any bearing on this matter? SC&H Group: We have assumed that the stock options are incentive stock options. This type of option is not taxable when granted or exercised, only upon disposition. This may not be considered a disqualifying disposition because you inherited the stock option from your husband. The immediate sale should qualify as a taxable event, however, there could be holding period and basis issues that should be reviewed. Greg, Baltimore: After filing my 2005 tax return, I received a notice from Baltimore City for past-due taxes from the 2004/2005 tax year, which I was not aware were outstanding. I paid the additional tax owed this year (2006). Can I claim these taxes on my 2006 tax return next year, or do I need to file an amended return for 2005? SC&H Group: If you itemize your deductions on Schedule A of your Form 1040, you can expense your Baltimore City taxes in the year in which they were paid. Therefore, you should deduct the taxes on your 2006 return, rather than amending your 2005 return. Allan Levin, Annapolis: Under itemized deductions on Schedule A, Item No. 5, am I supposed to deduct the amount of state taxes that appear as Item No. 17 on my W-2? SC&H Group: That is correct. In addition, if you have any local taxes in Box 19 of your W-2, you can deduct those on Schedule A, Line 5, as well. One deduction often missed here is to add any state taxes owed on your 2004 return that were paid in 2005. Robert Thomas, Clinton: In 2001, my son-in-law and I bought several rental houses as tenants in common. He was never an active owner and only went on the deed because we thought it would make inheritance easier. At the time, we did a written agreement that I would pay all expenses and taxes, manage the properties and take all profits or losses with me as 99 percent owner and he as 1 percent. Now, I want to sell one house and use all the proceeds in a 1031 Starker exchange to buy some land. Does my son-in-law owe any Maryland or federal tax, since I will report all profits on my taxes? SC&H Group: The new property must be of equal or greater value than the old property, or a gain may be recognized. If you meet all of the 1031 requirements, there should be no profits recognized to either one of you since the gain should be deferred. Since you will be claiming all of the profits, your son-in-law should not owe any tax in the current year. Given your fact pattern, professional advice is strongly encouraged. Meghan, Joppa: I am a college student who works part time, but my job does not take out federal taxes from my weekly checks. What type of taxes do I need to file? SC&H Group: If your employer does not withhold taxes from your paycheck, you may be considered an "independent contractor." If you have net income of more than $400 a year, you are required to pay self-employment tax. This is done by filing Schedule SE. The purpose of this form is to pay the Social Security, Medicare and federal taxes that are not being withheld by your employer. One half of the amount you pay can be deducted on page one on your individual tax return (Form 1040, Line 27). You are also required to report your income and any related expenses on Schedule C. The Schedule C and Schedule SE should be attached to your 1040. Stew, Pikesville: Are Maryland tax stamps and transfer fees on the sale and purchase of a home deductible on federal tax returns? SC&H Group: Maryland tax stamps and transfer fees are not deductible for federal income taxes as an itemized deduction. Rather, the amount you pay for them is added to your basis in the property. Therefore, when you ultimately sell the property, your basis will be higher and you will not have to recognize as much gain. Nick Costa, Gambrills: I am a freelance musician. I have [been] filing a Schedule C, and showing a profit at it, for several years. I have space in my basement that I use to learn material, to teach in and to hold rehearsals. I also use my PC to learn and transcribe tunes, advertise [and to] communicate with employers and with prospective clients. While my performances usually occur away from the home, my ability to perform, and thus earn income, depends upon my ability to learn the material, which occurs in my office space. Someone suggested my home office deduction may not apply, since I don't earn income there. Is a home office deduction applicable here? SC&H Group: The Internal Revenue Code allows individuals to take a home office deduction if they meet certain criteria. You may be eligible for the deduction as long as your home is your principal place of business. A "principal place of business" is the sole location in which you perform your trade or business' day-to-day administrative and/or managerial activities. Based on your facts, it appears that the deduction may be applicable. Editor's note: Last week's response to the following question contained incomplete information on qualifying for head of household. We are including the question again with a clarified response as a correction. regrets the error. Jennifer, Ronkonkoma, N.Y.: I filed for divorce [more than] a year ago, [and I am] currently still married. My husband and I have lived apart since December of 2004. I have sole custody of our 2-year-old child. I currently and for the past year have been living at my aunt's house, in which I do pay rent and share household expenses. Now, my question is, can I claim head of household, and if so, what proof do I need to have to claim this? Thank you. SC&H Group: A married taxpayer will be considered unmarried, and therefore eligible for head of household status, if the taxpayer's spouse did not live in the household during the last six months of the year and the household is the primary home for a dependent child of the taxpayer. This is true, even if the taxpayer waives the dependency exemption for that child to the noncustodial parent.
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