Is Diminished Value A Tax Deductible Casualty Loss? Or Are The Porter Ranch Homeowners Out of Luck?
On October 23, 2015, Southern California Gas Company discovered a leak in its Aliso Canyon underground gas storage facility, which provides natural gas reserves for Los Angeles and surrounding communities. The leak has made national headlines and was still ongoing as this article was being prepared in early February 2016. The company has estimated that it will be able to plug the leaking well sometime in late February.
Porter Ranch is a community of single-family homes, which is immediately adjacent to and above the facilities that maintain the vast underground gas storage facility. In excess of 5,000 families have been temporarily relocated or are in the process of relocating from the community because of health hazards.
This raises a unique question related to the decline in value of the homes in the Porter Ranch community. Is there a case for them to claim a tax-deductible casualty loss due to diminished value? If so, they could be looking at a substantial tax deduction that could apply to multiple years.
Case law suggests the answer to the allowance of a casualty loss deduction under IRC section 165(a), (as limited by IRC section 165(c)(3)), because the decline in value of homes affected by the Aliso Canyon leak depends on whether the decline in value is permanent or temporary.
Income Tax Regulation, section 1.165-7, requires an exclusion from a casualty loss deduction of any loss attributable to a “general market decline,” referred to by numerous court decisions as “temporary buyers resistance.” One court described “temporary buyers’ resistance” as “the loss of present value of property generated by a fear of future casualty damage” (See Finkbohner v. United States, 788 F.2d 723, at 725 (11th Cir. 1986)). Using this principle, courts have held that a market value decline caused by “buyer predictions that future casualties would cause further damage” is not deductible. “The claim of loss must await the (future) event” (parenthesis added). (See Kamanski v. Commissioner, 477 F.2d 452 (9th Cir.1973)” which deals with a California mud slide which did minor damage to taxpayer’s property but demonstrated the existence of dangerous soil conditions.”)
The Kamanski court case went on to say: “The thought is that a loss of present value generated by a fear of future damage is not a section 165(c)(3) casualty for the present owner because there is only one real future loss, and the future owner can claim it when the future disaster occurs.”
However, the 11th Circuit Court of Appeals in Finkbohner, referenced earlier, acknowledged the Kamanski case, with the majority agreeing that temporary declines in value do not produce a deductible casualty loss but that a permanent decline in value would do so. “It is different,” the court commented, “when the impact of the flood on the market value shows itself not wholly or chiefly in the expectation that additional floods will in future occur, but more directly in (permanent) changes in the neighborhood … that will outlast the fresh recollection of disaster” (parenthetical added as this appeared to be a key factor).
The issue is, did the gas leak cause a permanent decline in the value of property?
In Philmon, William F. v. U.S., (1999, DC FL) 84 AFTR 2d, the court denied the taxpayer’s claim for diminished property value reasoned that a disaster has a detrimental effect lasting “only as long as people remembered the disaster.” The Finkbohner case—referenced earlier, suggesting a permanent decline in value—is one that will “outlast the fresh recollection of disaster.”
Court cases base their opinion in no small part on people forgetting about the incident that caused the decline in value, making the decline temporary. However, under California Civil Code (commencing at Section 1102), the seller of a real property of 1 to 4 dwellings is required to provide the buyer with a Real Estate Transfer Disclosure Statement (TDS) before the transfer of the property occurs. Thus, even if potential buyers have forgotten about the gas leak, the disclosure will refresh their “recollection of the disaster.” The reality is that a potential buyer would be influenced and thus the price would be adversely affected.
Therefore, it is arguable that the decline in value is, at least in part, permanent.
Relevant cases rely heavily on competent appraisals that must carefully differentiate the components of the loss. The loss from physical damage (if any) must be distinguished from the loss due to the buyer’s resistance, and the buyer’s resistance-related loss component must be separated into the portion that is “temporary” and “permanent.”
Join the discussion. Do you think Porter Ranch area property values with be affected long term?
Chief Technical Officer of ClientWhys, Lee Reams, EA co-authored this article. Please send interview requests or questions about this subject to firstname.lastname@example.org.
Disclaimer: The opinions discussed here are hypothetical and are based upon taxpayers being able to establish with the IRS that the decline in value due to buyer resistance is in whole or in part permanent. Consult with your tax professional or attorney before taking any action.