As fires rage and rampage through large areas of California, the destruction of residences, outbuildings, and commercial buildings has been widespread. K·Coe Isom has been fielding questions and concerns from many of our clients regarding their property casualties, and therefore, we’d like to share an informative overview of frequently asked questions with the intent to minimize taxes on insurance proceeds due to fire loss.
The rules can be complex, however, and frequently large amounts are at stake—for both businesses and residences.
Please reach out to a K·Coe Isom tax expert with any questions, or advisory on how your unique situation should be treated to create the most tax advantages.
FAQs to Minimize Taxes on Insurance Proceeds
Q: HOW DO I DEFER, OR AVOID, TAX ON GAINS WHICH MAY RESULT FROM CASUALTIES SUFFERED?
While most taxpayers think of casualties as causing losses (as is typically the case), in some situations gains may result from insurance payments in excess of the taxpayer’s basis in thedamaged property.
Example. A home is destroyed by fire. The owner (taxpayer) had purchased the home years ago for $100,000 and this amount remained the owner’s tax basis (i.e., the owner made no capital improvements to the home). The home’s value had risen to $300,000 and the owner had it adequately insured. After the fire, the owner’s insurance company paid the owner $260,000. For tax purposes, the owner has a gain of $160,000 on the casualty ($260,000 insurance payment minus $100,000 tax basis).
However, the gain resulting from insurance payments for casualty might not be immediately, or ever, taxed.
Specifically, tax on a casualty gain may be deferred under the involuntary conversion rules. Furthermore, when the property that suffered the casualty is the taxpayer’s principal residence, the gain may be avoided altogether, as discussed below.
Q: WHAT CONSTITUTES INVOLUNTARY CONVERSIONS?
If a taxpayer uses all of the insurance proceeds received from a casualty to purchase replacement property within a required period (described below), the casualty gain will not be taxed.
However, the basis of the replacement property is reduced by the untaxed gain. Thus, the gain is deferred but not avoided, (i.e., it is “built in” to the replacement property).
Example: If the taxpayer has a $20,000 casualty gain and within the required period uses all of the insurance proceeds to buy replacement property for $100,000, the taxpayer’s basis in the replacement property is only $80,000. The required period begins at the time of the casualty event and ends (generally, two tax years after the tax year in which the first payments resulting in gain are received), but might end later because of a taxpayer request—or in the case of certain disasters (see below). Property qualifies as replacement property if it’s “similar or related in service or use” to the property that was destroyed.
Q: HOW DOES THE BASIS RULE APPLY TO REPLACEMENT PROPERTY?
Gain will be recognized to the extent the cost of the replacement property is less than the amount of the insurance proceeds.
Example: Let’s say the taxpayer has a $50,000 basis in an asset which is destroyed in a casualty and receives $80,000 in insurance proceeds. The casualty gain is $30,000. Within the required period, the taxpayer buys replacement property for $70,000– $10,000 less than the insurance payment received from the casualty. In this case, the taxpayer will have to include $10,000 of the $30,000 casualty gain in gross income—the amount of the insurance payment not spent on replacement property. (Note, under the basis rule discussed above, the taxpayer’s basis in the replacement property in this example would be $50,000—the $70,000 cost minus the $20,000 of untaxed gain.)
Q: WHAT IS CONSIDERED A PRINCIPLE RESIDENCE, AND ARE THERE EXCLUSION RULES?
Where the property damaged by the casualty is the taxpayer’s home, it may be even easier to avoid tax on a casualty gain. As you may be aware, if you used your home as your “principal residence” (e.g., not merely as a vacation home) for at least two years out of the previous five, you can exclude up to $250,000 of gain on its sale ($500,000 for married couples filing jointly, as long as the use tests are met by both spouses). This exclusion cannot be used more than once in a two-year period.
Significantly, for our purposes, these exclusion rules apply to gains from the destruction of the home as well.
Thus, casualty gains of up to $250,000 ($500,000 for married couples) can be excluded from gross income if the destroyed property is a principal residence.
If the casualty gain on a home exceeds the amount of the exclusion, the excess amount can be deferred under the involuntary conversion rules. In this case, to defer the remainder of the gain, the cost of the replacement property need only be equal to the insurance proceeds minus the excluded amount.
Example. A single taxpayer’s home is destroyed by a hurricane and the taxpayer is paid $400,000 by his insurance company. The taxpayer’s basis in the home was $100,000 so the casualty gain is $300,000. The first
$250,000 of this gain is excluded from gross income under the rules that apply to sales or exchanges of principal residences. The remaining $50,000 of gain is deferred under the involuntary conversion rules as long as $150,000 ($400,000 minus $250,000) of the insurance payment is spent, within the required period, on replacement property.
Q: WHAT TAX RULES APPLY UNDER A FEDERALLY-DECLARED DISASTER?
Additional tax help may be available if your home is destroyed by a casualty that is part of a federally-declared disaster.
Special rules make it easier to avoid gain on insurance payments you receive for your personal property damaged in the disaster. And, the involuntary conversion timing rules are expanded to allow you a four-year period calculated similarly to the two-year period described above. Further, a five-year period calculated similarly to the two-year period described above applies for certain disasters designated by statute.