Got a grant? Uncle Sam wants you!

Immediately following Hurricane Katrina we claimed a casualty loss on our federal tax return (See the "Katrina Emergency Tax Relief Act of 2005"). At the time we didn't have access to a CPA - and we weren't completely sure how to calculate our loss. As a matter of fact -- at that time we still had no clue just how much we had lost. We gathered receipts for repairs up until that time and tried to put together estimates for future repairs from contractors, FEMA, and the SBA. Even with such sketchy methods - we had to carry our loss back as far as the 2002 tax year.

Fast forward to this year when our CPA agreed that the MDA Katrina Homeowners Grant proceeds should be deducted from our previous claimed loss for tax purposes despite the fact that no one at the IRS who was contacted could actually tell us whether or not this was necessary.

The amended return resulted in owing the IRS a good chunk of money (we basically had to give the 2005 tax relief back) and a whole bunch of errors. We promptly paid this good chunk of money but said errors then resulted in a string of scary certified letters from the IRS every three weeks or so -- claiming various amounts of unpaid taxes that must be paid before asset seizure began. We were actually very sorry that we opened this can of tax worms.

(I can't think of any can of tax worms that we'd be happy to open...)

After a lot of phone calls, internet searching, and talking with the CPA -- we have learned a couple things that I feel are quite important to share with my blog readers considering that many of you may be in the same position whether you know it or not.

1. If you claimed a loss on your 2005 return for Hurricane Katrina - and if you later received a home grant from the MDA program... You will have to either a) reduce the previous claimed loss by some IRS voodooesque formula and pay any subsequent taxes or b) include the proceeds from the grant in income on an amended return for the year you received the grant. Yes - interest and penalties will be assessed.

From the IRS website (http://www.irs.gov/businesses/small/article/0,,id=171341,00.html) FAQ for Hurricane Victims:

(10/16/07) Q: How do individuals treat grants in the maximum amount of $150,000 that the Louisiana Recovery Authority (LRA) and the Mississippi Development Authority (MDA) make to compensate them for the damage to or destruction of their primary homes by Hurricane Katrina?

A: In general, the recipient of an LRA or MDA grant must reduce the amount of any casualty loss attributable to the damaged or destroyed primary residence by the amount of the LRA or MDA grant. However, if the individual properly claimed a casualty loss deduction and in a later year (for example, 2007) receives the grant as reimbursement for the loss, some or all of the grant proceeds may be required to be included in income in the year of receipt under the "tax benefit rule."

2. Because we filed our 2005 return on time - and did not take advantage of the extensions for filing that were provided to people in the Katrina zone we were forced to attempt loss calculations on our own and using estimates and receipts for repair as a basis for our loss. Even the IRS agrees this isn't the best method:

Under the law, a personal casualty loss is determined by taking the smaller of:

• The cost or other basis of the property (reduced by any insurance reimbursement), or
• The decline in fair market value of the property as measured immediately before and after the casualty (reduced by any insurance reimbursement).

The cost of repairs may, in certain cases, be used to measure the decline in fair market value, but it cannot be used by itself to determine the amount of the loss.

In October of 2006, the IRS issued a publication which outlined safe-harbor methods for determining the casualty loss resulting from Hurricane Katrina. Because we filed our taxes before this publication was released - we are now allowed to amend our 2005 return using one of the safe-harbor methods to recalculate our loss:

(10/4/06) Q: If you prepared your 2005 Form 1040 before Revenue Procedure 2006-32 was published, can you amend the 2005 Form 1040 to use one of the safe harbor methods in Revenue Procedure 2006-32 in determining a casualty loss from hurricane Katrina, Rita, or Wilma?

A: Yes

We think we have finally figured out what happened when we amended our original return to reduce our casualty loss and ended up owing the IRS more and more and more money as the months went on. The fact is - when we first filed our taxes in 2006 following our catastrophic loss in 2005 - there was no grant program. We had absolutely no hope of ever recovering our loss. We therefore filed our return as best we could on our own - and were not actually worried about whether or not we were underestimating the loss... as it stood we were already going back three years and would receive the maximum tax relief. Claiming a larger (even if more accurate) loss would not have been of any benefit to us and actually only raised the fear that an overzealous estimation would result in the IRS questioning our calculations.

That conservative calculation came back to bite us when we received our home grant. Our total grant amount came in at around $100,000. Please keep in mind that the MDA home grant is for home repair not covered by insurance only and does NOT include contents, outbuildings, landscaping, etc. The casualty loss we claimed on the 2005 return after being reduced by insurance and FEMA reimbursements came to $89,000. This loss included contents, etc. Our claimed loss was woefully underestimated, yes. And as a result - on paper - receipt of the grant actually resulted in a gain.

It all seems so clear now that I feel foolish. But for months we were scratching our heads trying to figure out how we could possibly have no net loss for tax purposes yet still actually be suffering the consequences of our loss. We were never made whole -- we definitely have not gained. And there it is.

And so - yet another amended return is in our future. And the future is still a bit bleak as our CPA warns us that amending again will bump us into high-risk for an IRS audit. Ironic that an audit is exactly what we were trying to avoid when we low-bid ourselves into this position.

An update to this post can be found here: http://vasavana.blogspot.com/2008/04/katrina-mda-and-tax-time-update.html