Tax Breaks for Hard Knocks

Things don’t always go as expected. Storms, thefts, injuries, and other unexpected events wreak havoc with financial plans. Fortunately, the tax law provides some relief in the form of deductions, exclusions, and tax payment options related to various types of losses and personal setbacks. Here is a roundup of breaks that apply.

1. Casualty and theft losses

If insurance doesn’t cover your financial losses from these unpleasant events, the tax law may help. You can deduct your uncompensated losses to non-business property as an itemized deduction. If the property was personal-use property, the loss from an event must be reduced by $100. Total losses for the year (after the $100 per event deduction) can be written off to the extent that it exceeds 10% of adjusted gross income.

Disaster losses. If the casualty loss occurred in a location declared eligible for federal disaster relief, you then have the option of deducting your loss for the year in which it occurred or in the prior year. For example, say you experience a disaster loss in March 2016. You can wait until you file your 2016 return in 2017 to deduct the loss. Alternatively, you can deduct it on your 2015 return. If you already filed your 2015 return, you can file an amended return to claim the loss for 2015 and receive an immediate tax refund.

2. Damages

You may suffer an injury from an accident, malpractice, or from some other cause. Damages from workers’ compensation for a job-related injury or illness are fully tax free.

If you receive compensatory damages from a legal claim arising from personal physical injury or illness, such as a malpractice action, they are not taxable. There is no dollar limit on this tax-free recovery.

However, if you receive damages for anything else, including punitive damages for a personal physical injury or illness, they are fully taxable. Attorney’s fees related to the taxable recovery, however, are deductible.

3. Restitution to the wrongfully incarcerated

Some individuals are wrongly convicted of a crime they did not commit, and with DNA today, some are exonerated. The federal government, 30 states, and the District of Columbia have compensation statutes granting monetary awards to such individuals. As part of the Consolidated Budget Act of 2015, in which tax extenders were included, there is a new rule. Individuals who receive restitution for being wrongfully imprisoned can exclude the recovery. There is no cap on this exclusion.

4. Offers in compromise

If you experience severe reverses that prevent you from paying an outstanding federal tax bill, you may be able to settle for less than the full amount owed. You can ask the IRS to agree to an offer in compromise (OIC). Unlike media ads that make it appear easy to obtain this relief, in reality, offers in compromise are granted only if there is legitimate cause for your inability to pay, or paying would result in a financial hardship.

The OIC program requires taxpayers to be proactive; it is not up to the IRS to suggest eligibility. You must submit a proposal and, in most cases, pay a fee for consideration. Any reduction in your liability depends on your ability to pay now and in the future, as well as your income, expenses, and assets.

Conclusion

The tax law lets you turn lemons into lemonade in some limited situations. Explore the options that apply to you.