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Court Rejects IRS Attempt to Use Obscure Provision to Deny Casualty Loss Deduction to Taxpayers (Parker's Federal Tax Bulletin: August 30, 2012)

On December 25, 2002, a married couple's home was destroyed by fire. Their insurance company, because of a paperwork snafu, rejected their claim and refused to pay. The couple took the insurance company to court and lost. Then they filed suit against the contractors they felt were responsible for the fire. Again, they lost. Finally, after receiving not a dime for the destruction of their home by fire, the couple took a casualty loss deduction on their tax return, which resulted in a tax refund claim of a little over $16,000. Using a little known and never litigated provision of the Code that was enacted over 25 years ago, the IRS denied the claim. According to the IRS, the couple had failed to file a timely insurance claim as required by Code Sec. 165(h)(5)(E).

In Ambrose v. U.S., 2012 PTC 238 (Fed. Cl. 8/3/12), the Court of Federal Claims rejected the IRS position and held that the taxpayers were entitled to the casualty loss deduction. In its conclusion, the court noted that the IRS described this case as one of first impression. The court agreed saying an informed observer might ask why it took the IRS 25 years to happen upon a taxpayer claiming a casualty loss who had lost a dispute with his insurer. However, the court said the more perplexing question was not why the issue came up so late, but why it came at all.


In August of 2002, Mark and Jennifer Ambrose took out a homeowners' insurance policy with Farm Family Casualty Insurance Company (Farm Family) on their home in Auburn, New York. That policy covered their home, other structures on the premises, personal property, and loss of use in the event of a fire or other peril insured against up to a limit of $216,000, subject to a $250 deductible. As is typical, this coverage was subject to a number of conditions.

In November 2002, the Ambroses' home was damaged by a dryer fire. In fulfillment of its obligations under the Ambroses' homeowners' policy, Farm Family contracted with Diamond's Air Clean and Construction (Diamond) to repair the fire, smoke, and water damage, while the Ambroses temporarily relocated to a nearby motel. In the early hours of December 25, 2002, a second, more serious fire occurred in the Ambrose home, totally destroying the house.

The Ambroses alleged that the second December fire was caused by Diamond's negligent workmanship. On January 29, 2003, Farm Family sent the Ambroses a letter, via both certified and regular mail, which noted that the insurance adjuster assigned to the case had requested that the Ambroses provide him with a Personal Property Inventory and such documentation had not been received. The letter said the Ambroses had 60 days in which to file a sworn statement regarding the fire. In February of 2003, the Ambroses hired an attorney, who contacted Farm Family inquiring whether anything else was required to process the Ambroses' claim beyond the information previously taken. On March 26 and April 7, 2003, a Farm Family representative conducted an examination under oath of each of the Ambroses. The Ambroses asserted that they never received either the certified or regular mail version of the January letter. They alleged that Farm Family did not request the sworn proof of loss until the April 7, 2003, examination, and that their attorney timely returned the sworn proof of loss on April 23, 2003. On June 12, 2003, Farm Family sent the Ambroses a letter denying coverage for the December 25th fire.

The Ambroses subsequently filed lawsuits against Farm Family and Diamond and lost. Following the final disposition of these lawsuits, the Ambroses filed an amended federal income tax return for 2007, in which they deducted a casualty loss of $167,619. The deduction eliminated their tax liability, leading them to claim a refund of $16,254. The IRS disallowed the claim saying it was fully disallowed because the Ambroses had failed to file a timely insurance claim as required by Code Sec. 165(h)(5)(E). According to the IRS, the Ambroses failed to file a timely insurance claim under Code Sec. 165(h)(5)(E) because they made a personal decision not to file the proof of loss on a timely basis.

History of Code Sec. 165(h)(5)(E)

Under Code Sec. 165(c)(3), an individual can generally deduct losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. To the extent such loss is covered by insurance, Code Sec. 165(h)(5)(E) provides that a casualty loss deduction is allowed only if the individual files a timely insurance claim with respect to the loss.

Before the enactment of Code Sec. 165(h)(5)(E), a number of courts considered whether, under Code Sec. 165(a), a taxpayer's election not to file an insurance claim for a loss precluded him from deducting the loss. In these cases, which involved casualty or theft losses, the IRS argued that the loss in question derived not from the casualty or theft itself, but from the taxpayer's intervening decision not to file an insurance claim. It contended that, as a result of the latter decision, the deduction did not correspond to a loss sustained . . . and not compensated for by insurance or otherwise, as required by Code Sec. 165(a). While this argument met some initial success, ultimately it was soundly rejected by the courts, first by the Tax Court, and then by various appellate decisions affirming the decisions of the Tax Court. In these cases, the taxpayers were allowed to deduct casualty losses under Code Sec. 165 even though they failed to file insurance claims.

In 1986, Congress intervened, denying a loss deduction under Code Sec.163(c)(3) for any loss covered by insurance unless the individual files a timely insurance claim with respect to the loss. The accompanying House Committee Report described the impetus for the new provision as follows:

The deduction for personal casualty losses should be allowed only when a loss is attributable to damages to property that is caused by one of the specified types of casualties. Where the taxpayer has the right to receive insurance proceeds that would compensate for the loss, the loss suffered by the taxpayer is not damage to property caused by the casualty. Rather, the loss results from the taxpayer's personal decision to forego making a claim against the insurance company. The committee believes that losses resulting from a personal decision of the taxpayer should not be deductible as a casualty loss.

Court Rejects IRS Position

The Court of Federal Claims rejected the IRS's position and held that the Ambroses could take the casualty loss deduction. According to the court, requiring an insured taxpayer to file a timely claim does not mean that the taxpayer must file with his insurer anything more than what qualifies, under his policy, as a basic demand for compensation.

With respect to the IRS argument that the Ambroses failed to file a timely insurance claim under Code Sec. 165(h)(5)(E) because they made a personal decision not to file the proof of loss on a timely basis, the court noted that the statute does not use either of the quoted phrases. Nor, the court observed, does the statute define what is meant by the phrase it actually employs files a timely insurance claim. According to the court, it was unclear whether Congress intended to include within the concept of an insurance claim the necessity of providing timely proof of that claim.

According to the court, the IRS's interpretation of Code Sec. 165(h)(5)(E) did not hold up for many reasons. The key phrase in that statute, files a timely insurance claim, takes its meaning from its individual terms. Webster's Dictionary defines the phrase file in relevant part, as to deliver . . . after complying with any condition precedent . . . to the proper officer for keeping on file or among the records of his office. The same lexicon defines a claim as a demand for compensation, benefits or payment, using as an example thereof one made under an insurance policy. These and like definitions, the court observed, strongly suggest a distinction between the filing of a claim and the subsequent submission of proof of the validity of that claim.

The court further noted that Reg. Sec. 1.165-1(a) appears to recognize that there is a distinction between the claim requirement in Code Sec. 165(h)(5)(E) and the proof a policy might require as a precondition to recovery. Under Reg. Sec. 1.165-1(a), a deduction is allowed for any loss actually sustained during the tax year and not made good by insurance or some other form of compensation. Further, the court said, Reg. Sec. 1.165-1(d)(2)(i), which defines the year in which the loss deduction may be claimed, specifically alludes to a taxpayer's abandonment of a claim for reimbursement as marking the proper time for taking a deduction. Applying the statute in accordance with its actual terms, the court stated, there was little doubt that, with respect to the loss in question, the Ambroses filed a timely insurance claim and Code Sec. 165(h)(5)(E) did not bar them from receiving a casualty loss deduction.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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