Chapter 7A – Casualty, Theft & Net Operating Loss Study Notes

Required Readings

• 2026 edition of the course textbook (chapter 7A focus).
• Corresponding CEK-designated sections (only the items shown on the slide are testable; additional textbook material is enrichment but strongly recommended).

Loss Deductibility: Big Picture

• Losses fall into three buckets:
– Trade or Business → Schedule C, fully deductible (subject to basis & at-risk limits).
– Income-Producing (investment/rental) → Schedule D or E, deductible within capital-loss rules.
– Personal → generally non-deductible unless an explicit IRC provision allows (main one: casualty/theft in a federally declared disaster area for 2018-2025).
• Key date window: 2018-2025 Tax Cuts & Jobs Act limits personal-casualty deduction to federally declared disasters.

Casualty & Theft Losses—Qualifying Criteria

• Event must be identifiable, sudden, unexpected, and unusual.
– Acceptable: fire, flood, hurricane, earthquake, car accident, theft (larceny, embezzlement, robbery).
– NOT acceptable: progressive deterioration (termites, dry rot, disease, normal wear), misplaced or lost items.
• Theft vs. Loss: misplacing property ≠ theft; must involve criminal act.
• Personal losses deductible only if disaster area is declared by the President (IRS publishes list & disaster codes that must be entered on Form 4684).
• Deduct in the year the loss occurs unless there is a reasonable prospect of full recovery —then wait until recovery amount is known.

Non-Deductible or Limited Situations

• Termite or insect damage.
• Tree disease.
• Decline in property value absent physical damage.
• Insurance-reimbursed amounts.
• Ordinary wear, tear, or maintenance.

Measurement of the Casualty/Theft Loss

Core Formula Components

1. Adjusted Basis (AB) – original cost minus depreciation (if any).

2. Fair Market Value (FMV) immediately before event.

3. FMV immediately after event.

4. Insurance or other recoveries.

Business or Income-Producing Property

• Complete destruction →
$\text{Deductible Loss} = \text{AB} - \text{Insurance}$
• Partial destruction →
$\text{Deductible Loss} = \min\left[ \text{AB},\; (\text{FMV}<em>{\text{before}}-\text{FMV}</em>{\text{after}}) \right] - \text{Insurance}$
• No requirement for federally declared disaster.

Personal-Use Property (Federally Declared Disaster ONLY)

Step 1 – Economic loss:
$L<em>0 = \min\left[ \text{AB},\; (\text{FMV}</em>{\text{before}}-\text{FMV}<em>{\text{after}}) \right] - \text{Insurance}$ Step 2 – Apply statutory reductions: $L</em>1 = L<em>0 - 100$ (one $100 reduction per event). Step 3 – Apply AGI floor: $\text{Allowed Loss} = \max\left[ 0,\; L</em>1 - 0.10\times \text{AGI} \right]$
• Result is claimed as an itemized deduction (Schedule A, line 15).
• If taxpayer uses standard deduction → no benefit.

Insurance, Reimbursements & Casualty Gains

• Recovered amounts reduce loss dollar-for-dollar.
• Excess reimbursement over basis creates a gain treated as a §1001 sale:
– Personal gains go to Form 4684 → Schedule D.
– Business gains go Form 4684 → Form 4797 (possible depreciation recapture) → Schedule D.
• Optional postponement/deferral rules (§1033 involuntary conversion) not covered in depth for this course.

IRS Forms Walk-Through

• Form 4684
– Section A: Personal-use property (requires disaster code).
– Section B: Business and income-producing property.
• Form 4797 – Sales of business property; receives casualty results from Section B.
• Schedule D – Capital gain/loss summary; receives line items from 4684/4797 for both personal & business gains.

Instructor Walk-Through Examples (Key Numbers)

1. Business equipment—complete destruction:
   • AB $=10,000$, FMV $=9,000$, no insurance.
   • Loss $=10,000$ (entire AB).

2. Business vehicle—partial:
   • AB $=10,000$; FMV before $=6,000$; FMV after $=4,000$; insurance $=500$.
   • Decline in value $=2,000$ → smaller than AB.
   • Loss $=2,000-500=1,500$.

3. Personal furniture (federally declared flood):
   • AB $=9,000$; FMV before $=12,000$; FMV after $=0$; insurance $=5,000$.
   • $L<em>0 = 9,000-5,000 = 4,000$. • $L</em>1 = 4,000-100 = 3,900$.
   • AGI $=30,000$ → 10 % floor $=3,000$.
   • Allowed $=3,900-3,000=900$ → Schedule A deduction.

4. Personal jewelry gain scenario: basis $=20,000$, insurance proceeds $=30,000$ → taxable gain $=10,000$ (reported on Schedule D via Form 4684).

Net Operating Losses (NOL)

• Purpose: smooth volatility so taxpayers with alternating profit/loss years pay tax similar to those with consistent earnings.
• Eligible losses: trade or business, casualty & theft, certain employee expenses (not personal).
• Post-2017 rule: carry-forward only (no carry-back except for limited farming & disaster cases).
• Deduction limit: each future year can offset up to 80 % of taxable income.
• Mathematical cap:
$\text{NOL\,deducted}<em>{\text{year n}} = 0.80 \times \text{Taxable Income}</em>{\text{before NOL}}$
• Unused NOL amount continues indefinitely until used.
• Does not create §199A QBI deduction; does not reduce self-employment tax—only taxable income.
• Computed on Form 1045 Schedule A; tracked on Schedule B; carried forward via a statement.
• Planning takeaway: aggressive business deductions in a loss year can provide long-term tax benefit, but timing of income matters.

Ethical & Practical Considerations

• Confirm disaster declarations (IRS Disaster Relief website) before claiming personal casualty loss.
• Document FMV via qualified appraisal or credible repair-cost evidence.
• Maintain all insurance paperwork—IRS will disallow deduction if recovery rights exist but claim not pursued.
• Tax preparer duty: apply $100 and 10 % AGI reductions per event, allocate between multiple owners, and keep evidence of basis computation (especially depreciation records).

Connections & Exam Tips

• Depreciation concepts (basis adjustments) tie into Chapter 8—know how prior §179 or MACRS impacts AB at time of loss.
• Casualty gains feed into capital-gain netting rules reviewed in Chapter 6.
• NOL interaction with marginal rates resembles tax-rate budgeting concepts from introductory chapters.
• Common exam triggers:
– Identify deductible vs. non-deductible events.
– Compute loss with partial destruction.
– Apply $100/10 % AGI personal limitation.
– Determine year of deduction/recovery.
– Calculate NOL offset limitation (80 % rule).