Under the tax rules, any loss sustained during the taxable year, a loss not covered or "made good" by insurance, can be claimed as a tax deduction. However, for a loss to be deducted, it must be evidenced by a "closed and completed transaction."
Casualty LossesLosses arising from fire, storm, shipwreck or other casualty are, clearly, tax deductible. Of course, even casualty losses must be due to a sudden, unexpected or unusual event to qualify as a tax deduction for the drilling operation.
Casualty losses, at least if they have been labeled as result of a legitimately declared "disaster," can be utilized to recoup taxes paid in the previous tax year. In essence, a casualty loss resulting from a declared disaster may be claimed as a tax deduction in the year preceding the tax year in which the disaster occurred.
If any driller sustains a loss from a disaster in an area subsequently determined by the President of the United States to warrant Federal assistance, special loss rules apply. Thus, a driller has the option of (1) deducting the loss on the tax return for the year in which the loss occurred or (2) deducting the loss on the tax return for the preceding tax year.
Naturally, the election to deduct a loss occurring in 2000 on the 1999 tax return must be made before the due date of the 2000 tax return (April 15, 2001 for calendar-year drillers; March 15, 2001 for calendar-year corporations).
Putting A Value On The Casualty LossWhen determining the actual amount of a tax deductible casualty loss, the fair market value (FMV) of the property Eimmediately before and immediately after the casualty shall be ascertained by competent appraisalE -- or so the rules dictate. This appraisal must recognize effects of any general market decline that may have occurred simultaneously with the casualty, affecting undamaged and damaged property. In other words, the tax deduction must be limited to the actual loss resulting from damage to the property -- not an overall decline in property values.
Alternatively, cost of repairs to the damaged property is acceptable evidence of loss of value. However, a driller must show: (a) the repairs are necessary to restore the property to its condition immediately before the casualty; (b) amount spent for those repairs is not excessive; (c) repairs are only for the damage suffered; and (d) value of the property after the repairs does not (as a result of the repairs) exceed value of the property immediately before the casualty.
Theft LossesThe tax rules clearly state theft losses are actually ôsustainedî in the year when the driller discovers the loss. In other words, a theft loss or even an embezzlement loss, is not deductible in the tax year in which the theft actually occurs unless that happens to be the year in which the driller discovers the loss.
Going one step further if, in the year of discovery, a reasonable possibility of reimbursement for that theft loss exists, the deduction cannot be taken until reimbursement is actually made or ruled out as a probability. Remember, the basic rule states for losses to be deductible, there must be a ôclosed transaction.î
Involuntary ConversionsFar more common than disaster losses, there are those occasions when business property is taken, legally or illegally. The government may, for example, legally take property by "condemnation." The loss of any business property by actions outside the driller's control are usually labeled as involuntary conversions.
These actions are unusual in that they often produce a gain. The local government that condemns your parking lot is required to reimburse you. That reimbursement frequently exceeds your basis in that property, resulting in a taxable gain.
Fortunately, the rules governing involuntary conversions permit the property to be replaced with property of a "like kind," eliminating the need to report and pay taxes on that gain.
Instead, the basis of the old "lost" property is transferred to the new, postponing the taxable gain to the future.
Losses -- and gains -- that result from involuntary conversion of depreciable business property or capital assets held for more than one year are covered by the general rules of Section 1231. Recognized gains and losses resulting from theft or seizure or an exercise of power or requisition or condemnation are treated as Section 1231 gains or losses.
AbandonmentFinally, there are losses every driller can control. Quite simply, a loss is allowed for abandonment of an asset.
All the driller must do is Òmanifest an intent to abandon the asset and make some affirmative act of abandonment.Ó The resulting loss is generally the adjusted basis or book value of the abandoned property.
If a depreciable business or income-producing asset loses its usefulness and is abandoned, the loss is equal to its adjusted basis. Obviously, the abandonment loss must be distinguished from anticipated obsolescence.
If a nondepreciable asset is abandoned following a sudden termination of its usefulness, a loss is also allowed in an amount equal to its adjusted basis. This applies to abandonment of an enterprise, and abandonment of intangible assets, such as contracts.
Lost profits rarely result in a legitimate tax deduction. For most other losses, however, tax deductions exist. Are you benefiting from your losses?