Tax relief for victims of natural disasters? Yes! Most of us will always remember the year 2020 as the year of the mask. But on top of the worldwide pandemic, street protests, and hotly contested election races, the U.S. had numerous natural disasters in 2020; hurricanes, an unprecedented number of wildfires, flooding and severe windstorms are just a few examples.
Congress typically passes legislation to provide some temporary tax relief to the victims of major disasters. Recently, Congress did just that when it passed the Taxpayer Certainty and Disaster Tax Relief Act of 2020. Are you a victim of a disaster? Does this bill cover the disaster that affected you? If so, there may be tax benefits that can help. First, a few definitions:
Definitions that help you understand the Tax Relief for Victims of 2020 Natural Disasters
“Qualified disaster area”
A Qualified Disaster area is an area that the president has declared a major disaster has occurred. Timing of the declaration is key. However, this is not the case if the area was declared as a disaster only due to COVID-19.
“Qualified disaster zone”
A qualified disaster zone is the portion of any qualified disaster area determined to warrant individual and/or public assistance from the federal government. Specifically assistance under the Robert T. Stafford Disaster Relief and Emergency Assistance Act.
“Incident period”
This is the period of time specified by the Federal Emergency Management Agency (FEMA) as when a disaster occurred.
Here is a current list of all affected areas and disaster dates occurring in 2020 in federal disaster areas.
Highlights of the tax relief for victims included in the Act of 2020
Qualified Disaster Distributions
If you suffered financial loss because of a qualified disaster, you are allowed to withdraw from your eligible retirement plans. Plans you may withdraw from include:
- 401(k) or 403(b)
- IRAs up to $100,000
You will not receive the 10% early-withdrawal penalty that applies if you are under age 59½. While the distribution is still taxable, you can chose to spread the income from the qualified distribution over a three-year period. This period begins with the year of distribution, rather than you paying all of the tax in the distribution year.
Re-contribution Option
Further, you can re-deposit any amount of the qualified disaster distribution in one or more re-contributions over the three-year period. This period begins on the day after the date of the distribution. For example, let’s say you take a qualified disaster distribution of $30,000 from your IRA on Dec. 10, 2020, and opt to spread the tax over years 2020, 2021, and 2022. You would include $10,000 of the distribution amount in each year’s return. In 2022, you are financially able to re-deposit the $30,000 to your IRA, which you do on Nov. 1, 2022. You would then need to amend your 2020 and 2021 returns to remove the $10,000 income from each year. And claim that refund of the taxes paid on those parts of the distribution. No distributions would be reported on your 2022 return.
Waived 20% Withholding Requirement
Normally, 20% of a retirement plan distribution is withheld as income tax. This 20% withholding rule will not apply to a qualified disaster distribution.
Distribution Timing
Only distributions made on or after the first day of the incident period of a qualified disaster and before June 25, 2021, can qualify.
Special Rule for Individuals Affected by More Than One Disaster
The $100,000 limitation is applied separately to distributions made with respect to each qualified disaster.
Re-Contributing Withdrawals for Home Purchases
If you are under 59½, the general rule is that you’ll owe a 10% penalty on the taxable part of a distribution from an IRA. (This also applies to an employer’s retirement plan). However, this 10% early-withdrawal penalty doesn’t apply to a distribution from an IRA used by a first-time homebuyer to pay the qualified acquisition costs for a principal residence. However, funds must be spent within 120 days of receiving the distribution. When a disaster strikes, a taxpayer’s plans to purchase or construct a home can be completely ruined. Thus, the funds from the withdrawal can’t be spent during the allotted time period.
To prevent the 10% penalty from kicking in when this happens, the act provides that any individual who received a qualified distribution during the period beginning 180 days before the first day of the incident period of a qualified disaster and ending 30 days after the last day of the incident period may make one or more contributions to an eligible retirement plan that total no more than the amount of the qualified distribution. It’s a bit complicated. However the re-deposit must occur during the period beginning on the first day of the incident period of the qualified disaster and ending on June 25, 2021.
How to qualify to make the recontribution
To qualify to make the re contribution, the amount distributed must have been intended to be used to purchase or construct a principal residence in a qualified disaster area, but was not so used due to the qualified disaster in that area.
If the funds are re-contributed, then the taxpayer can amend their tax return. This way they would receive a refund of the taxes paid on the withdrawal.
Increased Limit on Retirement Plan Loans
Generally, a loan from a qualified employer plan is treated as a plan distribution. This is unless the loan amount is at least the lesser of $50,000 or half of the present value of the employee’s nonforfeitable accrued benefit under the plan. An exception allows a loan up to $10,000 without regard to the accrued benefit rule. So such a loan must be repaid within five years. Longer repayment timelines can be used for a principal residence plan loan.
The act eased the requirements for qualified individuals who sustained an economic loss because of the qualified disaster, by doing the following:
How the Act helps Victims of 2020 Natural Disasters
- Increasing the maximum amount a plan participant or beneficiary can borrow from a qualified employer plan from $50,000 to $100,000. The “half of present value” test was changed to “the present value of the nonforfeitable accrued benefit of the employee.”
- Allowing a longer repayment period, generally of one year.
To be eligible for this relaxation of the plan-loan rules, the individual’s principal place of abode at any time during the incident period of any qualified disaster must have been located within the qualified disaster area of the qualified disaster.
Loss Limitations Revised
To deduct a personal casualty or disaster loss, each event must be reduced by $100. The overall loss must be reduced by 10% of the taxpayer’s adjusted gross income. The act modifies these rules by eliminating the 10% reduction and increasing the $100 reduction to $500.
Tax Relief for Victims that are Non-Itemizers
The personal casualty loss deduction is part of the itemized deductions claimed on Schedule A. So normally, a taxpayer who doesn’t itemize because their standard deduction is greater than the total of their itemized deductions won’t have any tax benefit from the casualty loss.
However, under the act, a taxpayer claiming a “net disaster loss” who does not itemize their deductions may add their “net disaster loss” to their standard deduction.
Employee-Retention Credit
The act provides an employee-retention credit for an employer that conducted an active trade or business in a qualified disaster zone at any time during the incident period of the qualified disaster AND when the trade or business became inoperable as a result of damage sustained because of the qualified disaster at any time during the period beginning on the first day of the incident period and ending on December 27, 2020.
The credit is 40% of the qualified wages of each eligible employee of the eligible employer for the taxable year. The qualified wages limit for any individual must be $6,000 or less. As a result, the maximum credit is $2,400 per employee.
How do I know if I’m eligible?
To be an eligible employee, the employee’s principal place of employment must have been in qualified disaster zone.
What are Qualified Wages?
Qualified wages are wages paid by the employer starting when the trade or business became inoperable at the principal location where the employee was employed. And lasting through the date when the business resumed significant operations at the employee’s principal place of employment. Or, if earlier, 150 days after the last day of the incident period of the qualified disaster.
- Qualified wages include wages paid without regard to to the following; whether the employee performed no services; performed services at a different place of employment than their principal place of employment; or performed services at their principal place of employment before significant operations resumed.
- Qualified wages generally do not include wages paid to the employer’s relatives. Nor wages that the employer uses in computing other tax credits, such as for the Work Opportunity Tax Credit, Research Credit, and others.
Other issues in the tax laws that add up to tax relief for victims
Extended Deadlines
The IRS has the authority to postpone certain tax deadlines by up to one year for taxpayers affected by a federally declared disaster. Examples of deadlines the IRS will postpone in disaster areas include those for filing income, excise, and employment tax returns; paying income, excise, and employment taxes; and contributing to IRAs.
When to Claim Disaster Losses
Special rules apply to losses that occur in areas that the president declares eligible for federal disaster assistance. The losses must result from the disaster. The FEMA website lists the designated disaster areas. Taxpayers may elect to claim the loss
- On the return for the year when it occurs, or
- On the preceding year’s return (either the original or an amended return).
When to take the loss depends upon a number of factors. Analyze the factors carefully. It’s critical to determine which year will be the most beneficial to take that loss. While some of the factors to consider include the tax brackets for each year, other include:
- the need for immediate cash,
- the effect on self-employment tax for those with business-disaster losses,
- whether the loss will be used up against other income for the year.
If the disaster loss is not fully used up in the year it is first deducted, it can create a net operating loss (NOL). This can then be deducted on either a prior year or future year return. (That depends on which year the loss occurred).
Insurance Proceeds
If a taxpayer’s home was damaged in a disaster, they qualify for special tax treatment. Specifically regarding certain insurance proceeds received as a result of the casualty. To qualify, the residence must be located in a presidentially declared disaster area.
Have you been in a qualified disaster? Have questions about the new provisions in the 2020 disaster legislation? Or if you want more information about the special tax rules for claiming disaster losses – please contact this office.
Video: COVID Tax Relief Act updates
