When dealing with the aftermath of a natural disaster, understanding how to calculate and report business loss, or in some cases manage taxable gain, is crucial. Los Angeles’ recent wildfires have had a devastating impact on businesses and caused substantial property damage and economic losses. Beyond the immediate toll on property and operations, businesses must also navigate the complex tax implications that follow.  From the tax effects of insurance proceeds to potential gain deferrals or loss deductions, there are essential aspects of tax optimization that can help mitigate the financial impact. 

CALCULATING BUSINESS LOSS

In general, taxpayers will claim disaster-related casualty gains and losses on their federal and California state tax returns when business property is damaged or destroyed by fire. Businesses are not subject to the same limitations as individual taxpayers, but losses must be calculated according to IRS guidelines. 

For losses related to federally declared disasters, such as the recent Los Angeles wildfires, businesses may claim losses on the tax return for the year the disaster occurred or the previous year. Claiming the loss in the previous year can expedite refunds but a careful analysis should be done to determine the best year to claim the casualty loss. 

The calculation for business gains and losses is very straight forward but differs when property is only partially damaged, as opposed to being completely destroyed. 

• If the property is completely destroyed, the gain or loss is calculated much like an ordinary sale of business property by subtracting the pre-casualty adjusted basis from any insurance proceeds received. 
• If the property is damaged but not completely destroyed, the gain or loss is calculated by subtracting the lesser of the pre-casualty adjusted basis or decrease in fair market value (as a result of the casualty) from any insurance proceeds received. 

EXAMPLE:

On Jan. 1, 2025, a business purchased a building for $200,000 in LA County. No improvements or additions were made to it. Later that month, a fire damaged a portion of the building. The FMV of the building was $190,000 immediately before the fire and $160,000 afterwards. The insurance company reimbursed the business owner $20,000 for the fire damage. Depreciation on the building before the fire totaled $1,000. The owner (as seen below) therefore has a deductible business casualty loss of $10,000.

IMPORTANT NOTE: For individual owners of flow-through entities, casualty losses are treated as nonpassive activities and are not subject to passive loss limitations. This means taxpayers can benefit from the losses as soon as they are claimed. This is true for both federal and California purposes.

REPORTING BUSINESS CASUALTY GAIN OR LOSS

Once disaster-related casualty gain or loss has been calculated, the next step is to properly report it. Casualty gains and losses are reported on Form 4684 - Casualties and Thefts. 

• Section A primarily deals with casualty gains or losses related to personal use property for individuals. Personal use property is property that is not used in a trade or a business. 
• Section B is used to calculate and summarize casualty gains or losses for businesses or income-producing property for the current tax year. 
  • Part I lists the property damaged or destroyed and calculates the casualty gain or loss. 
  • Part II summarizes the gains and losses for reporting on the applicable entity tax return. 
• Section C reports theft losses such as Ponzi-type investment schemes.
• Section D is used to elect to deduct a casualty loss resulting from a federally declared disaster in the preceding tax year. 
  • Under Internal Revenue Code (IRC) section 165(i) one may elect to deduct casualty loss in the preceding tax year from the year in which the loss occurred. Utilizing the IRC 165(i) election can help a business receive a quicker refund by deducting the loss on the preceding year’s tax return. In addition, the prior year may have taxable income that the loss can offset, while the disaster year may have little or no income. Taxpayers who make this election will complete Section D Part I and attach it to their amended return for the preceding year. If the election is not made, then the taxpayer will need to wait until the tax year has ended and deduct the loss in the year the disaster occurred, perhaps significantly delaying any refund due. 

INSURANCE PROCEEDS AND GAIN DEFERRAL

If a business received insurance proceeds for damaged or destroyed property, the owner may be concerned about the potential tax consequences. Fortunately, there are provisions in the tax code that allow for deferral of gain recognition under certain circumstances. Additionally, if an owner received insurance proceeds for business interruption or lost profits, it is important to understand the different tax treatment these funds receive.

DEFERRING TAXABLE GAIN ON PROPERTY LOSSES (IRC §1033)

Under Internal Revenue Code Section 1033, when property is involuntarily converted — such as being destroyed in a natural disaster — and insurance proceeds exceed the property’s adjusted tax basis, a taxable gain may arise. However, businesses may defer recognizing this gain if they reinvest the proceeds in similar property within a specified time frame.

Key Requirements for Deferral:

• Eligible Property: Replacement property must be similar or related in service or use to the damaged or destroyed property. It should be noted that for federally declared disaster areas, the permissible replacement property pool is broadened to include tangible property held for productive use in any trade or business. 
• Reinvestment Period: The standard reinvestment period is two years from the end of the tax year in which the gain is realized.
• Partial Reinvestment: If only part of the insurance proceeds is used to purchase replacement property, the deferred gain is reduced proportionally, with the remaining amount being taxable.
• Proper Documentation: Businesses should maintain records of insurance settlements, the original cost basis of lost assets and documentation of new acquisitions to support tax deferral claims.

TAXATION OF BUSINESS INTERRUPTION AND LOST PROFIT INSURANCE PROCEEDS

Unlike proceeds for property damage, insurance payments received for business interruption or lost profits are fully taxable in the year they are received. These proceeds are generally intended to replace lost revenue rather than compensate for the destruction of tangible property.

• Business Interruption Insurance: If a business receives payments to cover operating expenses and lost income during a period of closure, those amounts are considered ordinary income and subject to taxation.
• Lost Profits Coverage: If a business is compensated for lost profits due to an inability to operate, the proceeds are also taxed as ordinary income, similar to how the lost revenue would have been taxed had the business continued operations.

If your business was affected by the recent Los Angeles wildfires, understanding the tax implications of the disaster can be confusing and overwhelming. If you have questions about how this disaster will impact your business’s taxes, GHJ’s advisors are here to help.