Business Tax Preparation · Business expenses, deductions and credits

Casualties, thefts, and condemnations

An event that destroys or takes business property can produce a loss or a gain, and the two are governed by different sections. IRC § 165 measures the loss. IRC § 1033 defers the gain. A single fire can produce both, on different assets, in the same year.

The rule

The loss. a deduction is allowed for any loss sustained during the taxable year and not compensated for by insurance or otherwise^TY2026Verified 2026-08-21IRC § 165(a), opened at law.cornell.edu/uscode/text/26/165 (IRC § 165(a)), measured by the adjusted basis provided in IRC § 1011 for determining loss on a sale — so a cash-method lender's unpaid interest, never included in income, has no basis and produces no deduction^TY2026Verified 2026-08-19IRC § 166(b) — https://www.law.cornell.edu/uscode/text/26/166 (IRC § 165(b), IRC § 1011). For an individual, for an individual the deduction is limited to losses incurred in a trade or business, losses incurred in any transaction entered into for profit though not connected with a trade or business, and — subject to IRC § 165(h) — losses of other property arising from fire, storm, shipwreck or other casualty, or from theft^TY2026Verified 2026-08-21IRC § 165(c), opened at law.cornell.edu/uscode/text/26/165 (IRC § 165(c)) — but a business loss is within IRC § 165(c)(1) and is not touched by the personal-casualty restrictions.

How much. the lesser of the decline in fair market value from immediately before the casualty to immediately after, or the adjusted basis of the property^TY2026Verified 2026-08-21Reg. § 1.165-7(b)(1), opened at law.cornell.edu/cfr/text/26/1.165-7 (Reg. § 1.165-7(b)(1)), except that where business or income-producing property is totally destroyed and its fair market value immediately before the casualty is less than its adjusted basis, the adjusted basis is treated as the amount of the loss^TY2026Verified 2026-08-21Reg. § 1.165-7(b)(1), closing sentence, opened at law.cornell.edu/cfr/text/26/1.165-7.

Item by item. a business or profit-seeking loss is computed by reference to the single, identifiable property damaged or destroyed, so a building and the trees around it are measured separately — while for a personal residence the improvements are treated as an integral part of the property^TY2026Verified 2026-08-21Reg. § 1.165-7(b)(2)(i) and (ii), opened at law.cornell.edu/cfr/text/26/1.165-7 (Reg. § 1.165-7(b)(2)).

When, for a theft. a loss arising from theft is treated as sustained in the taxable year in which the taxpayer discovers it^TY2026Verified 2026-08-21IRC § 165(e), opened at law.cornell.edu/uscode/text/26/165 (IRC § 165(e)).

The gain. where property is compulsorily or involuntarily converted, by destruction, theft, seizure, requisition or condemnation or the threat or imminence of one, into property similar or related in service or use, no gain is recognised at all^TY2026Verified 2026-08-21IRC § 1033(a)(1), opened at law.cornell.edu/uscode/text/26/1033 (IRC § 1033(a)(1)); otherwise where the conversion is into money or into dissimilar property, gain is recognised only to the extent the amount realised exceeds the cost of replacement property purchased within the replacement period, and only if the taxpayer elects^TY2026Verified 2026-08-21IRC § 1033(a)(2)(A), opened at law.cornell.edu/uscode/text/26/1033 (IRC § 1033(a)(2)(A)) within beginning on the date of disposition or the earliest date of the threat or imminence of requisition or condemnation, whichever is earlier, and ending 2 years after the close of the first taxable year in which any part of the gain is realised — or later if the Secretary designates on application^TY2026Verified 2026-08-21IRC § 1033(a)(2)(B), opened at law.cornell.edu/uscode/text/26/1033 (IRC § 1033(a)(2)(B)).

Condemnation of business real property. on the condemnation of real property held for productive use in a trade or business or for investment, property of a like kind to be so held is treated as similar or related in service or use — a wider test than the ordinary one, and the replacement period is 3 years^TY2026Verified 2026-08-21IRC § 1033(g)(1) and (g)(4), opened at law.cornell.edu/uscode/text/26/1033 (IRC § 1033(g)(1), (g)(4)).

Basis afterwards. the basis of replacement property purchased in a transaction that deferred gain is its cost decreased by the gain not recognised, allocated among several properties in proportion to their costs^TY2026Verified 2026-08-21IRC § 1033(b)(2), opened at law.cornell.edu/uscode/text/26/1033 (IRC § 1033(b)(2)).

Current figures

How it works in practice

Ask first whether the event produced a loss or a gain. Insurance proceeds exceeding the adjusted basis of destroyed property produce a gain, however catastrophic the fire felt. The loss provisions never engage, and the question becomes whether IRC § 1033 lets the gain be deferred. A single event commonly produces a gain on the insured building and a loss on uninsured contents.

Measure a business casualty loss item by item. a business or profit-seeking loss is computed by reference to the single, identifiable property damaged or destroyed, so a building and the trees around it are measured separately — while for a personal residence the improvements are treated as an integral part of the property^TY2026Verified 2026-08-21Reg. § 1.165-7(b)(2)(i) and (ii), opened at law.cornell.edu/cfr/text/26/1.165-7 (Reg. § 1.165-7(b)(2)(i)). The regulation gives its own example: a building and the ornamental or fruit trees around it are measured separately, not as an integral part of the realty. This produces a larger deduction than the personal-property approach, because each item’s decline is capped by its own basis rather than by the basis of the whole.

And the cap is the lesser of two things. the lesser of the decline in fair market value from immediately before the casualty to immediately after, or the adjusted basis of the property^TY2026Verified 2026-08-21Reg. § 1.165-7(b)(1), opened at law.cornell.edu/cfr/text/26/1.165-7 (Reg. § 1.165-7(b)(1)). The decline in fair market value, or the adjusted basis — whichever is smaller. So a fully depreciated machine destroyed in a fire produces no loss at all, whatever it was worth, because its adjusted basis is zero.

Except where business property is totally destroyed. where business or income-producing property is totally destroyed and its fair market value immediately before the casualty is less than its adjusted basis, the adjusted basis is treated as the amount of the loss^TY2026Verified 2026-08-21Reg. § 1.165-7(b)(1), closing sentence, opened at law.cornell.edu/cfr/text/26/1.165-7 (Reg. § 1.165-7(b)(1), closing sentence). Where the property was worth less than its basis and is completely gone, the basis is the loss. That is the one place the “lesser of” rule is switched off, and it exists because a decline-in-value measure would give a deduction smaller than the taxpayer’s actual unrecovered cost.

Insurance reduces the loss, and can turn it into a gain. a deduction is allowed for any loss sustained during the taxable year and not compensated for by insurance or otherwise^TY2026Verified 2026-08-21IRC § 165(a), opened at law.cornell.edu/uscode/text/26/165 (IRC § 165(a)) allows a deduction only for a loss “not compensated for by insurance or otherwise,” so the proceeds come off before anything else. A business that is fully insured has no casualty loss deduction; it may well have a IRC § 1033 gain instead.

A theft loss belongs to the year of discovery. a loss arising from theft is treated as sustained in the taxable year in which the taxpayer discovers it^TY2026Verified 2026-08-21IRC § 165(e), opened at law.cornell.edu/uscode/text/26/165 (IRC § 165(e)). Not the year of the theft, and not the year the taxpayer gives up hope of recovery — though a claim for reimbursement with a reasonable prospect of recovery postpones the loss until the claim is resolved.

IRC § 1033 is elective and one-directional. where the conversion is into money or into dissimilar property, gain is recognised only to the extent the amount realised exceeds the cost of replacement property purchased within the replacement period, and only if the taxpayer elects^TY2026Verified 2026-08-21IRC § 1033(a)(2)(A), opened at law.cornell.edu/uscode/text/26/1033 (IRC § 1033(a)(2)(A)) defers gain only, and only if the taxpayer elects. It never defers a loss — a loss on an involuntary conversion is deducted under IRC § 165 in the ordinary way. And it defers only to the extent the proceeds are reinvested: proceeds pocketed are gain recognised.

The condemnation rule is materially more generous. on the condemnation of real property held for productive use in a trade or business or for investment, property of a like kind to be so held is treated as similar or related in service or use — a wider test than the ordinary one, and the replacement period is 3 years^TY2026Verified 2026-08-21IRC § 1033(g)(1) and (g)(4), opened at law.cornell.edu/uscode/text/26/1033 (IRC § 1033(g)(1), (g)(4)). Two advantages over the general rule. The replacement test becomes like-kind rather than “similar or related in service or use,” so condemned farmland can be replaced with an apartment block. And the replacement period is three years rather than two. Both are confined to real property held for productive use in a trade or business or for investment, and neither reaches stock in trade.

Then IRC § 1231 sorts the character. A recognised gain or loss on business property held long enough enters the IRC § 1231 netting, where a net gain is capital and a net loss is ordinary. The casualty provisions decide the amount; IRC § 1231 decides what kind of income it is.

How this has changed

The business side of this topic is stable. Neither IRC § 165(a), (b), (c)(1) or (e), nor IRC § 1033, nor Reg. § 1.165-7 was amended by Pub. L. 119-21, so the 2026 rules are the 2025 rules.

The personal side is not stable, and the difference matters for a preparer who handles both. IRC § 165(h)(5) confines an individual’s deduction for a personal casualty loss — one not connected with a trade or business or a transaction entered into for profit — to losses attributable to a federally declared disaster, with a limited offset against personal casualty gains. That restriction was enacted by Pub. L. 115-97 § 11044 and made permanent by Pub. L. 119-21 § 70110, in the same section that made the suspension of miscellaneous itemized deductions permanent. Nothing in it touches a business loss, which is within IRC § 165(c)(1), and the distinction between the two is now permanent rather than temporary.

And the practical effect of the 2017 changes runs through this topic sideways. Because bonus depreciation and expensing have let businesses recover the cost of equipment far faster than before, a great deal of business personal property now has a zero or near-zero adjusted basis. A casualty loss measured by the lesser of the decline in fair market value from immediately before the casualty to immediately after, or the adjusted basis of the property^TY2026Verified 2026-08-21Reg. § 1.165-7(b)(1), opened at law.cornell.edu/cfr/text/26/1.165-7 is capped by that basis, so the faster cost recovery of the last decade has quietly reduced casualty loss deductions to nothing for a large class of assets — while making a full insurance recovery on the same asset a taxable gain rather than a wash. That interaction is not in any single provision; it follows from putting two of them together.

Exam focus

Decide gain or loss before anything else. Compare the proceeds with adjusted basis, not with what the asset was worth or what it would cost to replace.

For a loss, apply the lesser-of rule and remember the exception for totally destroyed business property. For a business, measure each identifiable item separately.

For a gain, know that IRC § 1033 is elective, that it defers only to the extent of reinvestment, and that the replacement period is two years — three, with a wider like-kind replacement test, where business or investment real property is condemned.

Finally, remember that IRC § 165(e) puts a theft loss in the year of discovery and that a claim with a reasonable prospect of recovery pushes it further still.

Check yourself

1. A fire destroys equipment with an adjusted basis of $0 and a fair market value of $45,000. It was uninsured. What is the casualty loss?

Answer: Nothing. the lesser of the decline in fair market value from immediately before the casualty to immediately after, or the adjusted basis of the property^TY2026Verified 2026-08-21Reg. § 1.165-7(b)(1), opened at law.cornell.edu/cfr/text/26/1.165-7 (Reg. § 1.165-7(b)(1)) limits the loss to the lesser of the decline in fair market value and the adjusted basis, and the adjusted basis is zero. The rule in where business or income-producing property is totally destroyed and its fair market value immediately before the casualty is less than its adjusted basis, the adjusted basis is treated as the amount of the loss^TY2026Verified 2026-08-21Reg. § 1.165-7(b)(1), closing sentence, opened at law.cornell.edu/cfr/text/26/1.165-7 does not help, because it substitutes the adjusted basis, which is also zero.

2. A business receives $900,000 of insurance on a warehouse with a basis of $500,000 and spends $820,000 on a replacement warehouse within the period. What gain is recognised?

Answer: $80,000. where the conversion is into money or into dissimilar property, gain is recognised only to the extent the amount realised exceeds the cost of replacement property purchased within the replacement period, and only if the taxpayer elects^TY2026Verified 2026-08-21IRC § 1033(a)(2)(A), opened at law.cornell.edu/uscode/text/26/1033 (IRC § 1033(a)(2)(A)) recognises gain only to the extent the $900,000 realised exceeds the $820,000 cost of the replacement. The remaining $320,000 of the $400,000 gain is deferred, and the basis of replacement property purchased in a transaction that deferred gain is its cost decreased by the gain not recognised, allocated among several properties in proportion to their costs^TY2026Verified 2026-08-21IRC § 1033(b)(2), opened at law.cornell.edu/uscode/text/26/1033 gives the new warehouse a basis of $820,000 less $320,000, or $500,000.

3. A city condemns a business’s parking lot. May the business replace it with an office building, and how long does it have?

Answer: Yes, and three years. on the condemnation of real property held for productive use in a trade or business or for investment, property of a like kind to be so held is treated as similar or related in service or use — a wider test than the ordinary one, and the replacement period is 3 years^TY2026Verified 2026-08-21IRC § 1033(g)(1) and (g)(4), opened at law.cornell.edu/uscode/text/26/1033 (IRC § 1033(g)(1)) treats like-kind real property held for productive use or investment as similar or related in service or use where business or investment real property is condemned, and IRC § 1033(g)(4) substitutes three years for two in the replacement period.

4. A storm damages a company’s office building and the mature trees on its grounds. How is the loss computed?

Answer: Separately for each. a business or profit-seeking loss is computed by reference to the single, identifiable property damaged or destroyed, so a building and the trees around it are measured separately — while for a personal residence the improvements are treated as an integral part of the property^TY2026Verified 2026-08-21Reg. § 1.165-7(b)(2)(i) and (ii), opened at law.cornell.edu/cfr/text/26/1.165-7 (Reg. § 1.165-7(b)(2)(i)) requires a business loss to be determined by reference to the single, identifiable property damaged, and the regulation gives a building and its trees as its own example. The integrated treatment applies only to property not used in a business or held for profit.

5. A business discovers in the current year that funds were stolen four years ago, and has no prospect of recovery. In which year is the loss deducted?

Answer: The current year. a loss arising from theft is treated as sustained in the taxable year in which the taxpayer discovers it^TY2026Verified 2026-08-21IRC § 165(e), opened at law.cornell.edu/uscode/text/26/165 (IRC § 165(e)) treats a theft loss as sustained in the taxable year in which the taxpayer discovers it, so no earlier return is amended. With no reasonable prospect of recovery there is nothing to postpone it further.