Changes to Personal Casualty Loss Deduction Could Affect 401(k) Hardship Withdrawals

In the wake of any new tax law, there are always issues that cause problems when the new provisions are actually put into practice. One such issue with the recently enacted Tax Cuts and Jobs Act: hardship withdrawals from a 401(k) plan to address a personal casualty loss of a principal residence may no longer be allowed unless the loss is attributable to a federally declared disaster area.

The issue stems from changes that temporarily modify the deduction for personal casualty and theft losses under Code Section 165(h). Under the provision (found in section 11044 of the conference report), a taxpayer may now claim a personal casualty loss only if such loss was attributable to a disaster declared by the president under section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act. These changes are applicable for tax years 2018 through 2025.

Under prior law, a taxpayer generally could claim a deduction for property losses not compensated by insurance or otherwise that were attributable to losses arising from fire, storm, shipwreck or other casualty. The losses generally were deductible only to the extent that the aggregate net casualty and theft losses exceeded 10% of adjusted gross income.

Treasury regulations (Treas. Reg. §1.401(k)-1(d)(3)(iii)) list six “safe harbor” reasons (such as medical, education and funeral expenses and to prevent foreclosure) to permit plans to allow hardship distributions if the distribution is made to address an “immediate and heavy financial need of the employee.” For a typical 401(k) plan that allows hardship withdrawals, one of the six reasons specifically cites Section 165:

Expenses for the repair of damage to the employee’s principal residence that would qualify for the casualty deduction under section 165 (determined without regard to whether the loss exceeds 10% of adjusted gross income).

While the provision temporarily eliminates personal casualty losses unless they are the direct result of a declared disaster area, it’s not clear whether the drafters intended for the provision to affect 401(k) hardship withdrawals. It could be the result of an unintended consequence.

Nevertheless, based on the language in the statute and existing regulations, it would appear that qualified hardship withdrawals to repair a severely damaged principal residence are effectively eliminated unless in a federally declared disaster area, pending any future guidance.

Client alerts by the Groom Law Group and DrinkerBiddle discuss the issue in further detail.

Additional Relief for Wildfire Victims?

Meanwhile, prior to adjourning last year, the House of Representatives approved legislation (H.R. 4667) extending to victims of the California wildfires access to their 401(k)s and similar plans without incurring IRS penalties or immediate tax liability. The Senate, however, still has not considered the legislation.

This proposed tax relief for the wildfire victims was approved as part of an $81 billion supplemental disaster relief bill to help communities in Texas, Florida, Puerto Rico and California rebuild after experiencing devastating losses from the recent natural disasters.

In general, the legislation provides relief from the 10% early withdrawal penalty for qualified distributions up to $100,000 made on or after Oct. 8, 2017, and before Jan. 1, 2019. Distributions must be made by an individual whose principal place of residence was in a wildfire disaster area and who sustained an economic loss due to the wildfires.

It is anticipated that this disaster relief legislation for the wildfire victims will eventually be approved, possibly as part of broader government funding legislation.

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