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Many homeowners are suffering with damages to their residences from purportedly tainted Chinese drywall. The IRS has provided guidance on if and when damages may give rise to a casualty loss deduction under Code Section 163(h). The IRS Associate Chief Counsel indicates that such damages will meet the casualty loss requirements of being sudden, unexpected, or unusual, if the Environmental Protection Agency or the Consumer Safety Product Commission determines that such drywall emits chemical fumes that causes the extreme or unusual damages.

In computing such losses, taxpayers need to keep certain things in mind. First, casualty losses generally are subject to a $100-per-casualty floor and the 10%-of-AGI limitation. Second, the taxpayer will need to prove the amount of the loss, which is the loss in fair market value (but no greater than the taxpayer's adjusted basis in the residence).

In computing this loss of value, the taxpayer will need to separate out (and not deduct) loss in value relating to market declines in value. Since the U.S. residential market has undertaken a general decline in recent years, this separating of loss between drywall damage and market loss may be difficult to prove. Taxpayers may instead want to avail themselves of Treas.Reg. § 1.165-7(a)(2)(ii) which, if met, will allow the loss to be computed instead based on the cost of repairs.

The IRS also noted that costs incident to a casualty, such as temporary alternative housing, are nondeductible personal expenses and not casualty losses.

Taxpayers must also take the deduction in the proper year, which is generally the year the loss is sustained, or when a determination is made that the loss will not be fully reimbursed.

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