Rev. Proc. 2010-36: Something Smells Foul (Again!) for Chinese Drywall Victims
On September 30, 2010, the Internal Revenue Service (IRS) issued Rev. Proc. 2010-36 addressing casualty loss deductions under §165(a) of the Internal Revenue Code1 for taxpayers whose personal residences were found to contain defective Chinese drywall. Although useful to some taxpayers, for many the guidance is a narrowly drawn safe harbor procedure that may provide limited or no relief for the taxpayer who does not have the means to repair or remediate the property. Even worse, Rev. Proc. 2010-36 does not provide any safe harbor relief for the many taxpayers who purchased defective drywall homes as investment property and trade or business property during the building boom. Unfortunately, it appears that more than walls stink for Chinese drywall victims.
Since 2001 — and more significantly in the construction boom from 2003 to 2007 — property owners across the United States have been reporting the corrosion of copper wiring, failures of household appliances with copper components, and the presence of sulfur gas odors within their homes and buildings. Occupants of the structures reported suffering from nausea, eye irritation, and respiratory problems.2 Florida and Louisiana, states with the largest glut of new housing construction from real estate booms and a series of devastating hurricanes in the mid 2000s, sourced the majority of these reports.3 The Florida Department of Housing (DOH) received its first report in June 2008, and after further complaints from homeowners and inquiries made by the Environmental Protection Agency, the DOH launched an investigation in conjunction with the Consumer Safety Product Commission (CSPC) to determine the cause of the problems and assess any possible health risks.4
Several South Florida builders knew the source of the problem as early as July 2006. The odors and corrosion were the result of a high sulfide gypsum and oil shale mix of drywall imported from China between 2001 and 2008.5 As some homeowners were quietly moved by builders to begin remediation in late 2008, news of the epidemic known as “Chinese drywall,” “defective drywall,” “corrosive drywall,” and “problem drywall” became widespread in January and February 2009 as it hit local and national media.
Although the presence of Chinese drywall was unmistakable for the many homeowners suffering from the rotten egg odor the drywall had been emitting for years, it was not until January 2010 that the CSPC released guidelines to officially identify the presence of the corrosive drywall.6 Since the announcement of these guidelines, over 3,805 reports of problem drywall in 43 states, the District of Columbia, Puerto Rico, and American Samoa have been logged with the CSPC.7 Unfortunately, there are a significant number of unreported cases as a result of speculators who defaulted on mortgages and walked away from homes they never lived in or even saw, leaving the banks to “clean up” the mess. While some homes need only a few boards removed, the majority of homes must be completely gutted of all drywall, corroded copper, and electrical wiring at a cost typically in the hundreds of thousands of dollars. Acknowledging the gravity of the situation, the state of Florida mandated the removal of all corrosive drywall homes from county tax rolls in 2010 and requested assistance from the Federal Emergency Management Agency (FEMA).
The Government’s Response
FEMA rejected Florida’s request for damage assessment and financial assistance for homeowners by stating that it did not meet federal emergency or disaster guidelines.8 This insult was met with further injury months later when the IRS issued Rev. Proc. 2010-36 to provide “help” for defective drywall victims.9 Under Rev. Proc. 2010-36, the IRS provides a safe harbor method for taxpayers whose personal residences were affected by the corrosive drywall. After properly identifying the presence of the corrosive drywall under the CSPC guidelines, the IRS mandates that a taxpayer must remediate the home and repair any such damage caused by the problem drywall to take a deduction under its safe harbor method. As with all personal casualty loss deductions under §165(c)(3), §165(h) limits the deduction to losses exceeding $100 and 10 percent of the taxpayer’s adjusted gross income for the tax year.10
Nowhere within §165 is there a requirement that a taxpayer actually pay for the repair or replacement of an asset that has been damaged, destroyed, or stolen. The underlying policy reason for this is simple: The losses or damages may be so great that taxpayers cannot afford to make themselves whole again. The IRS recognized this concept when it promulgated Rev. Proc. 2006-32 to deal with taxpayers whose personal use real property was destroyed or damaged as a result of Hurricanes Katrina, Rita, and Wilma.11 The IRS allowed homeowners to take a deduction for the damage done to their home as assessed by insurance agencies, contractors, or cost indexes.12 None of these three safe harbor valuation methods provided under Rev. Proc. 2006-32 required the taxpayer to reach into his or her pocket to remediate the home to take advantage of the deduction. Additionally, under Rev. Proc 2006-32, the IRS waived the $100 and 10 percent of adjusted gross income loss limitations under §165(h).
The stark contrast between the relief granted to the 2004 and 2005 hurricane victims under Rev. Proc 2006-32 and the drywall victims under Rev. Proc. 2010-36 in what has been called the “silent hurricane” becomes even more apparent when a taxpayer elects to take a deduction outside of the safe harbor method. Under Rev. Proc. 2010-36, taxpayers with Chinese drywall electing not to follow the safe harbor procedure must prove every element of a §165 casualty loss, including whether defective drywall qualifies for a loss deduction under §165, including the measure of the loss, which can often be a complicated and confusing task in a defective drywall case.
The Basics of §165 Casualty Losses for Personal Property
Under §165(a), taxpayers may deduct losses not compensated by insurance or other means of reimbursement.13 Losses not connected with a trade or business or a transaction entered into for profit may be deducted under §165(c)(3) provided that such losses are caused by fire, storm, shipwreck, theft, or other casualty. Although the Internal Revenue Code and Treasury Regulations fail to define what “other casualties” qualify under §165, the court in Matheson v. Commissioner, 54 F.2d 537 (2d Cir. 1931), fashioned requirements for “other losses” that were later adopted by the IRS in Rev. Rul. 72-592 and in later publications.14 A casualty is damage, destruction, or loss of property that results from an identifiable event that is sudden, unexpected, and unusual in nature.15 The damage or loss must be unexpected in that it is not ordinarily anticipated or resulting from the intent of the person suffering the loss.16 The IRS finds any loss to be “unusual” when it is extraordinary, nonrecurring, and outside the day-to-day activities of the taxpayer.17 The majority of “other casualty” loss cases presented before the courts hinge upon the suddenness of the loss as being the key factor.18 Casualty losses must be swift and precipitous; progressive deterioration through a steadily operating cause does not qualify under §165.19
In addition to the Matheson test, courts have also relied on the Fay test to determine if a deduction is allowed as an “other casualty.” In Fay v. Helvering, 120 F.2d 253 (2d Cir. 1941), the court stated that the word casualty “denotes an accident, a mishap, some sudden invasion by a hostile agency….”20 Under this analysis, cases of negligent workmanship and defective automobiles deductions are denied. In Smith v. Commissioner, 608 F.2d 321 (8th Cir. 1979), the taxpayer bought a Porsche and within months had to bring the car in numerous times for service. While it could not be determined whether the Porsche was defective or the mechanics were negligent in their repair of the vehicle, the court found that mechanical failures do not qualify as a casualty loss absent external intervening forces.21 Similarly, in Mann v. DIR, 40 AFTR 2d 77-5708 (N.D. Il. 1977), the court stated that it was not convinced that “poor factory workmanship constitutes unexpected or hostile external force which can be analogized to a fire, storm or shipwreck.”
The allowance of a casualty loss deduction in any given year is dependent upon whether the loss is evidenced by closed and completed transactions as fixed by identifiable events in the taxable year.22 Under this approach, the year of the discovery of the loss is not necessarily the year a deduction is taken on a return. The taxpayer must look to all forms of reimbursement to determine the true amount of its loss. The discovery of the loss and the denial of reimbursement (by insurance carriers and other parties deemed responsible for the loss) exist as events beginning and ending a completed transaction. Where there is no reasonable prospect of recovery or reimbursement, the casualty loss deduction is taken during the year of the loss.23 If during the year of the loss there exists a claim for reimbursement for which there is a reasonable prospect of recovery, taxpayers may only take as a deduction such amounts of the loss that will not be reimbursed.24 If in a later year, a casualty loss claim is settled and the amount of recovery is less than what the taxpayer anticipated, the remaining unrecovered portion of the loss may be deducted in that year.25 Amounts that are later reimbursed after a deduction is taken on a return must be included as income in the year received.26
Typically, amounts deductible under §165(a) are limited to the lesser of 1) the difference between the fair market value of the property immediately prior to the casualty and the fair market value of the property immediately after the casualty, and 2) the amount of the adjusted basis prescribed in Treas. Reg. §1.1011-1 for determining the loss from the sale or other disposition of property involved. The lesser of these two amounts is then adjusted for reimbursement, compensation, and salvage value.27 After determinations are made as to the possibility of reimbursement, losses qualifying under §165(c)(3) are then limited under §165(h). Each loss is subject to a $100 loss limitation.28 After deducting $100 from the loss, a taxpayer may take a deduction for the amount of the loss that exceeds 10 percent of the taxpayer’s adjusted gross income.29
Corrosive Drywall Analysis
Notwithstanding the fact that Rev. Proc. 2010-36 identifies defective Chinese drywall as a qualifying casualty under §165(a), when a taxpayer decides not to follow the safe harbor outlined therein, all of the elements of a casualty loss must be satisfied before a loss deduction can be taken. In this regard, the damage resulting from corrosive drywall was both entirely unexpected and well outside the realm of the day-to-day activities of the taxpayers suffering the loss. The issue for a corrosive drywall casualty loss deduction is the suddenness of the loss. Following the rulings in Black v. Commissioner, 36 T.C.M. 1347 (1977), and Nelson v. Commissioner, 27 T.C.M. 158 (1968), courts have repeatedly recognized a 30-day window between the initial colonization of southern pine beetles and the death of a tree as sufficiently “sudden” enough for an allowance of the loss.30 Although courts generally disallow termite infestations under §165, numerous extraordinary cases involving such infestations over periods of months have been allowed.31 Similarly, in Shopmaker v. United States, 119 F. Supp. 705 (E.D. Mo. 1953), the court allowed a deduction for a termite infestation over a 14-month period. In Shopmaker, the homeowners purchased a home in December 1949, after reports that the house was termite free and discovered swarms of termites in the kitchen in February 1951.32 Although it could not be determined when the infestation began, the infestation itself was sudden and unexpected enough to allow the loss despite the length of time for the damage to develop and to discover the infestation.
Depending on the size of the home, the drywall installation process takes anywhere from days to weeks to complete and is well within the periods prescribed under Shopmaker and Black. As with termites, the installation (corollary to an infestation) of the corrosive drywall was the event of the casualty even though such installation and the resulting damage are spread out over a period of time. In cases where a taxpayer purchased a new home containing corrosive drywall during the building boom, the loss technically occurs at the time of purchase even though most taxpayers were not aware of the loss until much later. Using the Matheson analysis, the purchase of a home with defective Chinese drywall is not an anticipated act or within the intent of the purchaser. The event is an unusual one in that although taxpayers typically own or buy one or more houses during their lifetime for personal, investment, or business use, the purchase of a property that unbeknownst to the buyer has a latent defect that severely devalues the property and renders it virtually uninhabitable is an unusual and nonrecurring act. Whether there was an installment of corrosive drywall or the purchase of a corrosive drywall home, the damage caused by the drywall over a period of months and years should not be confused with the identifying event (installation or purchase) and the determination of what is the casualty.33
The fact of the matter is that unlike Smith and Mann, the “silent hurricane” is not a mere case of a machine malfunction or negligent workmanship. Defective drywall rises to the level of and can be analogized to a major disaster such as a hurricane, fire, earthquake, or tornado. The damages, estimated to fall between $15 billion and $25 billion, exceed the costs of Hurricane Katrina.34 This is a catastrophic event that affected thousands of homeowners in a relatively short period of time. Entire neighborhoods in Florida and other states have been abandoned with no relief in sight.
Despite the rulings in Smith and Mann, corrosive drywall should still be considered a casualty loss under §165. In Rev. Proc. 2010-36, the IRS and Treasury Department provide a safe harbor method for certain damage resulting from corrosive drywall “in view of the unique circumstances surrounding the damage.”35 According to the revenue procedures, taxpayers choosing to take a deduction outside of the safe harbor method must only establish that “the damage, destruction, or loss of property resulted from an identifiable event that is sudden, unexpected, and unusual, and was not the result of progressive deterioration through a steadily operating cause.”36 Absent a requirement of “external forces” or “hostile agency” within the text of the revenue procedures, the IRS has lowered the threshold for affected homeowners to prove up a casualty loss related to defective drywall.
Assuming that a taxpayer can prove the defective drywall qualifies as a casualty loss, another issue for taxpayers electing out of the safe harbor treatment under Rev. Proc. 2010-36 is the amount and timing of the loss. As discussed above, the Internal Revenue Code and Treasury Regulations provide in most circumstances that the amount of the deduction under §165(c)(3) is the difference between the fair market value of the property immediately prior to the discovery of the loss and the fair market value of the property immediately after the discovery of the loss. In defective drywall cases, the IRS would likely argue that the timing and amount be based on 2009 and 2010 discovery dates, home values, and construction costs. However, this measure of the loss typically diminishes the amount of the actual loss for most taxpayers who bought at the peak of the real estate market (during the boom) and discovered the defective drywall long after. If a taxpayer could not afford to remediate his or her home today (which many taxpayers cannot), and if a taxpayer were to argue that the measure and timing of the loss is the fair market value of the home at the time of purchase and remediation costs based on construction costs at the time of the purchase, the measure of the loss is significantly greater than the measure of the loss at time of discovery based on today’s values and construction costs.
Even assuming arguendo that the measure of the loss is correct under Rev. Proc. 2010-36 (remediation costs), and still assuming that a taxpayer elects out of the safe harbor, this method of valuing the loss is not without problems. Looking back to late 2008 and early 2009 when homeowners first discovered that their homes had defective drywall and needed remediation, builders and contractors did not have any knowledge or established procedure as to how to remediate these homes. Estimates to remediate a home were quoted as high as 60 percent of the construction cost of the building.37 Today, companies experienced in remediation have lowered these costs with an average cost now estimated at around $60 per square foot.38 The dilemma for the taxpayer who discovers defective drywall in 2008, elects out of safe harbor treatment in 2010 or 2011, and cannot afford to remediate is still the same — in what year should the loss be deducted and in what amount? Because many taxpayers cannot afford to reach into their pocket and fix their homes today, valuing the loss based on purchase price and the costs to remediate at the time of purchase is a truer measure of the actual loss for these taxpayers than the measure of loss based on discovery date fair market value and today’s remediation costs. When taxpayers throw in the added confusion associated with the decrease in the value of the home as a result of the declining real estate market (which is a factor in determining the deduction under the Treasury Regulations), measuring the loss of a defective drywall casualty under §165 outside the safe harbor can be challenging.39
As discussed above, the ability of taxpayers to take these deductions is dependent on whether there exists a reasonable possibility of reimbursement for the loss or some other form of relief, such as debt forgiveness on a principal residence, that results in a closed and completed transaction. Whereas insurance companies promptly denied all Chinese drywall claims as latent defects, homeowners could resort to litigation against both the home builders and the manufacturers of the drywall, as many already have. Until a full assessment of the value of the claim is performed and any such lawsuit is settled or negotiations with a lender are finalized, taxpayers must continue to wait to take a deduction on their returns to the extent of any potential reimbursement.
Theft Loss as an Alternative Theory
The Treasury Regulations deem “theft” to include larceny, embezzlement, and robbery, but do not limit the definition of theft to such acts.40 In Edwards v. Bromberg, 232 F.2d 107, 110 (5th Cir. 1956), the court stated that theft is “a word of general and broad connotation, intended to cover and covering any criminal appropriation of another’s property to the use of the taker, particularly including theft by swindling, false pretenses, and any other form of guile.”41 In Khramer Wolf v. U.S., 56 AFTR 2d 85-6242 (Cl. Ct. 1985), an art dealer misrepresented a painting as the work of a well-known 19th century American painter and certified the authenticity of the painting to the buyer. The signature on the painting was a forgery, but it could not be determined whether the dealer forged the signature or that it occurred at an earlier date at the hand of another seller.42 Regardless of who forged the signature, the existence of a knowing and intentional act to defraud and mislead others as to the value of the object qualified the purchase as a theft loss entitling the taxpayer to a deduction.
Many of the affected drywall victims purchased brand new homes directly from reputable builders. Certain builders, including some well-known builders here in Florida, knew as early as summer 2006 that the homes they were building and selling were tainted with corrosive drywall.43 Despite the severe odor in these houses and despite declining sales for those properties beginning to present signs of toxic drywall (corroded pipes, faulty appliances, etc.), builders moved forward with sale after sale of homes with defective drywall without warning of the defect or the possibility thereof.44 The knowing misrepresentation or omission as to the quality and the value of the property is a theft under §165, amounting to a deduction so long as state law treats the omission or misrepresentation as a theft. Under a theft analysis, the measure of the loss is typically determined under §165(c)(2) without regard to the $100 and 10 percent of AGI limitations. As a result, a §165(c)(2) loss can be much greater than a loss under §165(c)(3). Madoff and other Ponzi scheme victims are typically granted relief under §165(c)(2), sometimes to the full extent of their basis. Some defective drywall taxpayers also fall into this category where builders knew of the problem and still built and sold defective homes.
Although the IRS has provided some relief for taxpayers affected with defective drywall through Rev. Proc. 2010-36, the relief provided is far less than the relief granted to hurricane victims from the mid-2000s or those individuals who fell victim to Ponzi schemes over the last several years. Despite the fact that the loss valuation and timing for claiming these losses for drywall cases is difficult to discern, the deductibility of these losses is legitimate and necessary for the victims of this crisis. Given the concentrated number of taxpayers affected by this plight and the extraordinary circumstances giving rise to the casualty, it is truly confounding that the government would take such precaution to tie taxpayers’ hands with such limited safe harbor relief. With all that has occurred in the last half decade (hurricanes, financial crisis, Ponzi schemes, and the like) leading the government to bail out or provide assistance to its citizens and private industry, it seems proper to provide Chinese drywall victims with the same broad relief provided other casualty victims especially in this challenging economic climate. Perhaps part of the reason for the IRS’ generosity for hurricane victims related to the taxpayers’ ability to collect on claims against homeowner policies which avoids the full burden of the catastrophe from falling on the government. With defective drywall claims, the insurance carriers have uniformly denied paying claims as a latent defect. As a result, the government is stuck footing the entire bill and may be the reason why the safe harbor relief provided under Rev. Proc. 2010-36 is so narrow.
1 All references made to the Internal Revenue Code shall mean the Internal Revenue Code of 1986 as amended.
2 CDC, Imported Drywall and Your Home,
3 American Industrial Hygiene Association, White Paper on Corrosive Drywall (October 10, 2010), http://www.aiha.org/news-pubs/govtaffairs/Documents/W-Corrosive%20Drywall-10-10-10.pdf (hereinafter White Paper on Corrosive Drywall).
4 American Association for Justice, Timeline of Key Events Regarding Defective Drywall (January 2010),
http://www.justice.org/resources/Drywall_TimeLine_10_05_09.pdf; Florida Department of Health, Timeline for Florida Department of Housing Events Relating to Imported Drywall, http://www.doh.state.fl.us/environment/community/indoor-air/timeline.html.
5 White Paper on Corrosive Drywall.
6 Consumer Product Safety Commission, Department of Housing and Urban Development, Interim Guidance – Identification of Homes with Corrosion from Problem Drywall
(January 28, 2010), http://www.cpsc.gov/info/drywall/interimidguidance012810.pdf.
7 CPSC, http://www.cpsc.gov/info/drywall/index.html.
8 WPBF.com, FEMA Rejects Florida’s Request for Chinese Drywall Help, http://www.wpbf.com/health/22869011/detail.html.
9 Rev. Proc. 2010-36, 2010-42 I.R.B. 439.
10 I.R.C. §165(h)(1)-(2).
11 Rev. Proc. 2006-32, 2006-28 I.R.B. 61.
13 I.R.C. §165(a).
14 I.R.S. Publication 547 (2010).
15 Rev. Rul. 72-592, 1972-2 C.B. 101; Matheson v. Commissioner, 54 F.2d 537, 539 (2d Cir. 1931).
18 See Hoppe v. Commissioner, 354 F.2d 988 (9th Cir. 1965).
19 See Matheson v. Commissioner, 54 F.2d 537 (2d Cir. 1931).
20 Fay v. Helvering, 120 F.2d 253, (2d Cir. 1941) (per curiam).
21 Smith v. Commissioner, 608 F.2d 321 at 322 (8th Cir. 1979).
22 Treas. Reg. §1.165-1(d).
23 Treas. Reg. §1.165-1(d)(2)(i).
24 Treas. Reg. §1.165-1(d)(2)(ii).
26 Treas. Reg. §1.165-1(d)(2)(iii).
27 Treas. Reg. §1.165-1(c)(4).
28 I.R.C. §165(h)(1). For losses prior to December 31, 2009, the loss must exceed $500.
29 I.R.C. §165(h)(2).
30 Moreover, the U.S. Tax Court has held, as a matter of law, in Smithgall v. United States, 47 AFTR 2d 81-695 (N.D. Ga. 1980), that “[a] mass attack of southern pine beetles in epidemic proportions is a sudden and unexpected occurrence causing an identifiable loss and is thus a deductible casualty within the meaning of Section 165(c)(3) of the Internal Revenue Code.”
31 See Rosenberg v. Commissioner, 198 F.2d 46 (8th Cir. 1952); Buist v. United States, 164 F. Supp. 218 (E.D. S.C. 1958); Winsor v. Commissioner, 278 F.2d 634 (1st Cir. 1960).
32 Shopmaker, 119 F. Supp. 705 (E.D. Mo. 1953).
33 See id. at 705 (E.D. Mo. 1953).
34 David Dybdahl, Chinese Drywall Creates Unprecedented Growth and Risk for Restorers, American Risk Management Resources Network (December 7, 2009), http://www.armr.net/chinesedrywall11-09(r).pdf, citing Jeff Casale, Insurers Fighting Claims over Chinese Drywall,
Business Insurance (November 2, 2009),
35 Rev. Proc. 2006-32.
37 David Dybdahl, Chinese Drywall Creates Unprecedented Growth and Risk for Restorers, American Risk Management Resources Network (Dec. 7, 2009), http://www.armr.net/chinesedrywall11-09(r).pdf.
38 Joseph J. Egan, United States Chinese Drywall Damage Update, Davis and Hosfield Consulting, LLC (August 31, 2010), http://www.mondaq.com/unitedstates/article.asp?articleid=107210.
39 Treas. Reg. §1.165-7(a)(2)(ii).
40 Treas. Reg. §1.165-8(d).
41 See also Bagur v. Commissioner, 603 F.2d 491, 501 (5th Cir. 1979); Farcasanu v. Commissioner, 436 F.2d 146, 149 (D.C. Cir. 1970); Boothe v. Commissioner, 82 T.C. 804, 815 (1984) (Hamblen, J., dissenting), rev’d 768 F.2d 1140 (9th Cir. 1985); and Gerstell v. Commissioner, 46 T.C. 161, 171-72 (1966).
42 Khramer Wolf v. U.S., 56 AFTR 2d 85-6242 (Cl. Ct. Oct. 25, 1985).
43 Aaron Kessler and Joaquin Sapien, Drywall Problems Known in 2006 but Kept Secret, Herald-Tribune (June 18, 2010), http://www.heraldtribune.com/article/20100618/ARTICLE/6181030?p=4&tc=pg&tc=ar.
Robert L. Spallina is a partner at Tescher & Spallina, P.A., in Boca Raton, where he focuses on wealth transfer planning for high net worth families. He is a former CPA and CFP with a B.S. in accounting from the University of Florida, a J.D. from Loyola Law School in Los Angeles, and an LL.M. in estate planning from the University of Miami School of Law.
Lauren A. Galvani is an associate at Tescher & Spallina, P.A., in Boca Raton. She received her B.A. in English, history, and political science from Boston College and graduated from the University of Miami School of Law with a J.D. and an LL.M. in taxation with a certification in international tax.
This column is submitted on behalf of the Tax Section, Guy E. Whitesman, chair, and Michael D. Miller and Benjamin Jablow, editors.