My personal art collection worth $1,000,000 was totally destroyed in an accident. The cost basis was also $1,000,000. This is a deductible casualty loss. I am in litigation against the insurance company and the liable parties. The recovery will be determined by the court in 2011 or later. I expect the recovery to be less than $1,000,000, but more precise estimate of the amount is up to me and my litigation attorney – and here we have choices.
What would be the best multi-year tax strategy?
1. Estimate the recovery at $0 (pessimistic), carry the loss forward several years;
2. Estimate the recovery at $800,000 (optimistic) and likely lower that expectation with every passing year, deduct accordingly – no carryovers;
3. Estimate the recovery at $500,000 (mid-way), carry forward one year, then lower the estimate if applicable, deduct and carry forward again.
Here are the rest of the data (assume all the figures to be the same for 2007 and the next several years): yearly income (wages) $300,000, state tax $20,000 (New York), mortgage interest $50,000, property taxes $10,000.
Essentially, in case 1 I take the $1,000,000 loss in 2007 and carry it forward to 2008 and 2009 (carry back is not beneficial for sure); in case 2 I take $200,000 every year 2007-2011 as the recovery expectations gradually diminish; in case 3 I carry forward from 2007 to 2008, then deduct another loss in 2009 and carry it over to 2010.
In every carryover year all benefits of other deductions (and exemptions: married filing jointly with one dependent) – total $80,000 or more each year – are lost. On the other hand if I deduct loss in increments it is reduced by 10% of AGI each time. There may be other factors influencing the total multi-year tax in each of the three scenarios. What are these factors? Which of the three approaches shall I take? Or is there a forth better way?