Process of Recovery

PART 2

7      NO GAIN OR LOSS

8      A LOSS

Tax Elections, Decisions, and Tax Consequences

When an event occurs, the first thing that you need to do for tax purposes is determine if there is a gain or a loss. Your first analysis may later change, but it will assist you in the early days of the recovery. It is important to keep the possibility of an alternate conclusion in mind.

It is also important to refrain from rushing into a loss claim on a tax return. The initial benefit may be very enticing, a later recovery that requires a reversal of the original loss can be very costly. The initial benefit may get you $15,000 in tax savings, but the later recovery could easily cost you $25,000 or more.

It is possible to have a gain in one category while having a loss in another category.

7      NO GAIN OR LOSS

There may be a no gain/no loss situation due to insurance proceeds not exceeding the cost basis of the damaged property, but exceeding the loss. Even if there is no gain or loss, it is advised that the following information should be part of the disclosures included in a tax return related to a catastrophe:

• Taxpayer(s) names and Federal Tax ID.
• The type of casualty and when it occurred (including, if available, the FEMA identification number).
• The date of the loss.
• That the loss was a direct result of the casualty.
• The information relates to the return for the taxpayer who owns the property (or the taxpayer is leasing and is contractually liable to the owner for the damage.)
• The city, county and state in which the loss event occurred.
• Any replacement costs incurred, appropriately detailed.
• Cost basis of property damaged.
• Insurance proceeds received or expected to be received

If the residence qualifies as a complete loss under Internal Revenue Code Section 121, triggering the $250,000 exclusion for the taxpayer and $250,000 for the spouse, any gain is eliminated for a married couple with less than $500,000 in total gain. However, a complete statement is required to claim the exclusion, and all relevant items should be reported.

8      A LOSS

To claim a deduction, the loss must be sustained according to the tax code, meaning it must have occurred and undergone the claims process, and subsequently settled. However, the definition of “settled” can be ambiguous. For instance, if a loss of $1,200,000 with a maximum insurance coverage of $800,000 has only received a $200,000 payout by the tax return due date, it may be reasonable to consider the excess loss of $400,000 ($1,200,000 less expected insurance payment of $800,000) as settled, even if the full policy limits have not been paid out.

If insurance covers $100,000 of a $150,000 loss, $50,000 can be considered sustained, even if the claim process is ongoing. If insurance pays $95,000, the remaining $5,000 can be deducted when the $95,000 is finalized.

The loss and cost basis are reduced by insurance proceeds. The loss can be determined using one of two methods discussed below.

Appraisal Method vs. Cost of Repairs Method

The Cost of Repairs Method compares the expense of necessary repairs to restore the property to its pre-event state with the adjusted cost basis of the damaged property, selecting the lower amount as the loss. Debris removal costs are factored into the total repair expenses. However, this deduction can only be claimed after the completion of repairs. If repairs are finalized in a subsequent year, the taxpayer files a return for that year to claim the loss. This method has its limitations: only repairs that return the property to its original condition are considered for the loss calculation, while any enhancements or upgrades are excluded.

Opting for the cost of repairs method doesn’t negate the need for an appraisal. It’s still crucial to determine the property’s value before the event to establish the lower of the actual cash investment or the appraised value for determining the adjusted cost basis prior to the loss event.

The cost of repairs method restricts taxpayers from using insurance funds to invest in a separate replacement property to qualify as a replacement for the damaged property. Repairs can include upgrades, but their costs are not considered when calculating the loss amount. Repairs mandated by building codes that don’t replicate the original construction also won’t be recognized by the IRS and may be considered disqualified improvements.

If a taxpayer uses epoxy on a cracked concrete slab and upgrades the kitchen counters from tile to marble, the cost of the marble would be excluded from the computation of the allowable loss, and since the concrete slab will not be replaced, the epoxy cost would also be excluded.

Under the law, the details of the repairs used to quantify the loss using the cost of repairs method must be traced to the completion of the repairs within a reasonable period of time after the event, considering the completion of the insurance claims process.

All of the restrictions inherent in the cost of repairs method disappear when using the Appraisal Method for determining the loss. Under the appraisal method, the taxpayer simply gets two appraisals prepared by a competent, qualified real estate appraiser. The first appraisal computes the value immediately before the loss event occurred. The second computes the value giving effect to the fact that the loss has occurred.

The second appraisal should specify and include the detrimental effects on FMV due to the debris that are present after the event. It should also specify: “The post-event appraisal does not give effect to any temporary buyer resistance that may be impacting the market immediately after the event.”

The appraiser doesn’t need to compute the difference between the two amounts. Instead, the taxpayers use Form 4684 to determine the appraisal loss, comparing it to the adjusted cost basis. The final loss is whichever is lower between the adjusted cost basis and the appraisal loss, after subtracting any applicable insurance proceeds from both the loss and the cost basis.

Using the appraisal method allows the taxpayer to use insurance funds for the repair and improvement of the damaged property or the acquisition of a replacement property. The insurance contract may impose separate limitations. There are no income tax limitations placed on the location of the replacement property. It does not even have to be located in the same state.

Expert personal property appraisers may be able to approximate the original cost and pre-event value of some contents.

Providing the appraiser with the scope of loss won’t help determine the property’s post-event value. The appraiser independently evaluates the value of a partially damaged structure.

Providing the scope of loss to the appraiser carries another risk: if the appraiser references it in any way, the IRS might mistakenly assume the cost of repairs method was chosen, even if the taxpayer opted for the appraisal method. Courts have ruled in favor of appraisers using their judgment, but facing an auditor unaware of this precedent could complicate the audit unnecessarily.

Determining and Reporting a Loss

When facing a loss, taxpayers must carefully determine its extent, including selecting the appropriate computation method. Loss determination relies on one of two computation methods, with the choice left to the taxpayer, although the IRS may question the outcome and propose an alternative method. Generally, taxpayer choices are upheld if adequately supported. However, the IRS may prevail if taxpayers lack proper supporting evidence. The two methods — appraisal and cost of repairs — are unlikely to produce equivalent amounts.

The loss computed using either method cannot exceed the adjusted cost basis of the property.

Reporting a Loss – FORM 4684

It’s important to determine the tax year in which the loss will be reported on a tax return, especially if the loss happens near the end of the year. The claims process can be complex and might extend beyond the end of the current year into the following year.

Once the loss has been determined, the next step is to determine the year it should be claimed. The disaster year is the year that claims are all settled. This is important as the regulations under Sec. 165(i) allow the deduction of the loss in the disaster year or the year immediately preceding the disaster year.

The decision to claim the loss in the year preceding the disaster year must be made by October 15^th of the year following the disaster year. The definition of the disaster year and the October 15^th deadline are important changes since 2016 that provide the taxpayer with a tremendous amount of flexibility.

Once the initial amount of the loss is determined, there are two adjustments that reduce the amount of the tax deduction. The first is that $100 for each event during the year is excluded. The amount of income that appears at the bottom of page one of the Form 1040 income tax return is called Adjusted Gross Income (AGI). The second adjustment requires that 10% of AGI must be deducted from the total of all casualties reported for the year. If the pre-adjustment losses total $50,000, all from one event, and AGI for the year is $100,000, the deductible loss will be $39,900 ($50,000 less $100, less 10% of $100,000).

PART 3

9           A GAIN

10         TIME PERIOD TO COMPLETE QUALIFIED REPLACEMENTS

11         STATUTE OF LIMITATIONS

12         QUALIFIED REPLACEMENT PROPERTY

13         SALE OF RESIDUAL LAND/OR HOLD FOR LATER SALE

9      A GAIN

For a gain to occur, the damaged property must be converted, or compensated, with cash or other dissimilar property, typically through insurance. This compensation must surpass the property’s cost basis. Once a gain arises, the taxpayer has two options: pay the tax or defer the gain by using the proceeds to acquire qualified replacement property. This aligns with Congress’s intent to restore taxpayers to their pre-event condition.

The taxpayer can have a gain by deducting the cost basis from the insurance proceeds. This computation doesn’t need to reduce the cost basis to the potentially lower adjusted cost basis from before the event.

Once it has been established that there is a gain, a gain is realized in the year that the actual cash proceeds exceed the cost basis of the damaged property. A decision must be made whether that gain will be recognized, reported on a tax return as taxable (essentially treated as a sale), or reported as an involuntary conversion gain to be deferred.

Tax Elections and Decisions

Determining whether a taxpayer has incurred a loss or a gain due to a catastrophic event can be complex. As discussed earlier, the cost is subject to multiple determinations. Moreover, the extent of the loss and the corresponding insurance recovery may not always be fully known when it’s time to file a tax return. Tax returns have set due dates and extensions are available, but they might not suffice for the circumstances. Taxpayers find themselves in a situation where they must file their return with the best available information at the time. Sometimes, an amended return may be necessary later to adjust the original filing, while in other cases, the adjustment must be addressed in a subsequent year’s filing.

Taxpayers should not postpone filing returns that are due under any circumstances. A late return can incur significant penalties. Even if the original return shows a loss and filing it late would not result in penalties, any subsequent amendment reporting taxable income could attract penalties.

Reporting a Gain

The initial crucial step, as discussed earlier, is determining whether a conversion into cash has transpired. If the insurance company offers a replacement property, there’s no conversion, and thus no tax implications are triggered. However, this scenario is quite uncommon. Typically, even when the insurance company arranges for the contractor, the insured is usually obliged to sign a contract with the vendor. In such cases, the insurance company issues checks payable to both the insured and the contractor.

Involuntary Conversion

Where money is involved and the proceeds exceed the cost basis, a gain is generated. If a decision is made to defer the gain, the transaction is reported as an involuntary conversion.

When opting for reinvestment, meticulous record-keeping is essential. This includes annually reporting the status of the reinvestment process, along with disclosing the received insurance proceeds. These reporting rules must be followed throughout the replacement period. As part of this process, it’s advisable for the taxpayer to outline repair plans to estimate whether all necessary expenditures will be completed within the required timeframe, or if an extension of the replacement period will be necessary due to factors beyond the taxpayer’s control.

The involuntary conversion is treated as a sale transaction. The tax code provision allows an exclusion of up to $250,000 per taxpayer, ($500,000 for married couples) on the sale of a primary personal residence may apply. Generally, the law (Revenue Code Section 121) requires:

1. The home must be used as a primary personal residence for 2 of the last 5 years (there are additional requirements that can affect this requirement).
2. The taxpayers must have owned the home for at least 2 years prior to the sale and
3. The taxpayers have not used the rule for at least 2 years.

Another requirement for gain resulting from damage to a personal residence is that the property must be “completely destroyed,” a term not defined by Congress. It’s evident in cases where a home has burned to the ground, but ambiguity arises when significant structural features remain. In a 2001 memo, the IRS outlined various conditions beyond a total burn scenario. Therefore, if your home has sustained significant damage, careful consideration should be given to the possibility of applying the exclusion.

The time to complete the repairs and the complexity of the repairs may also affect the decision to pay the tax or defer the gain.

Is partial taxation alongside partial deferral of gain possible? Yes. For instance, if the proceeds amount to $1,000,000 and only a portion represents gain, and if repairs are estimated to cost less than the full amount, one can report only the taxable portion, not exceeding the gain, and defer the remaining balance.

If any part of the gain is reported as taxable, it’s treated as a capital gain. To ensure it’s taxed at capital gain rates, the taxpayer must check for any capital losses deducted in the past five years, which were treated as ordinary losses, as these will require the gain be taxed at ordinary rates up to the amount of those prior ordinary losses.

Reporting A Deferral of The Gain

The IRS doesn’t offer a specific form for reporting gain deferral like it does for reporting loss (Form 4684). However, the code and regulations mandate specific information to be included in post-event replacement disclosures:

• Event identification – clear description including any federal or state disaster declarations
• Year(s) gain realized – the gain may be realized in more than one year, each year of realization must be reported
• Proceeds received less gain excluded = gain realized
• Gain recognized (taxable, partial, or full deferral)
• Identification of property lost – clear description including address of property for real property and cost investment
• Dates of loss and reinvestments
• Election to defer gain under indicating the appropriate code section
• Identification of replacement property(ies) or repairs – type of property, location

IRC Sec. 121 Unforeseen Circumstances

What if the taxpayer does not meet the three two-year requirements of the Code? The Code allows for a modification. Assume that the taxpayer moved into the property 6 months prior to the loss event. Six months is 25% of two years, so the taxpayer is entitled to 25% of the $250,000 exclusion. What if the taxpayer had been away from the home for four years prior to the event? That fifth year that they were at the home would qualify for 50% of the $250,000 exclusion.

10    TIME PERIOD TO COMPLETE QUALIFIED REPLACEMENTS

The law’s relief provision includes time restrictions to maximize tax deferrals of a gain, notably impacting taxpayers aiming to defer tax payment by replacing or repairing destroyed property. The replacement period starts at the catastrophic event’s occurrence, excluding acquisitions of potential replacement property before the event. Insurance negotiations can occur during this period, with payments potentially below the taxpayer’s cost basis for the destroyed property. Gain is only realized when cumulative insurance proceeds exceed the cost basis plus any IRC Sec. 121 exclusion applicable, triggering a second clock. This clock begins at the year’s end when gain is first realized and runs for two years (four for federally declared disasters involving primary personal residences). The entire period from loss to the end of the two- or four-year period constitutes the replacement period.

Assume a loss on October 10, 2020:

• The insurance company makes some payments in 2020.
• In 2021, the insurance company settles the claim that brings the proceeds to an amount in excess of the cost basis and any IRC Sec. 121 exclusion
• A gain has been realized in 2021
• The second clock starts to run at the end of 2021 for a four-year period for a primary personal residence ending on December 31, 2025

Extensions Of Time to Complete Replacement

What happens if the replacement period is ending, but the taxpayer can’t finish the replacement on time? While Congress expects compliance with time requirements, unforeseen circumstances may arise. Recognizing this, the law grants the IRS authority to extend the replacement period, the only instance where such authority is given in casualty and involuntary conversion situations.

To qualify for an extension, the taxpayer must provide a credible explanation. Valid reasons could include delays in lawsuit settlements affecting reinvestment plans or documented shortages in building supplies due to widespread rebuilding. The taxpayer must demonstrate a genuine effort to meet the deadline, with the extension being necessary due to circumstances beyond their control. Specific information must be included in the application, which can be a concise one-page letter sent to the designated IRS office. No specific form is required.

11    STATUTE OF LIMITATIONS

Under normal conditions, a tax return is subject to IRS scrutiny for a period of three years after it has been filed. In the case of an involuntary conversion, the period from the event to the year of the final reoccupation of the residence may span three or more years. This includes the receipt and the reinvestment of insurance proceeds up to the end of the statutory replacement period, plus granted extensions. All the returns for the years in which any of these activities occur remain open for examination for the period that ends three years after the notification to the IRS that the reinvestment has been completed. For example, if the event occurred in 2020, and the completion of the reinvestment is reported on the 2023 return on April 15, 2024, all returns for 2020 through 2023 are open for examination through April 15, 2027 (three years after April 15, 2024).

12    QUALIFIED REPLACEMENT PROPERTY

The law mandates that to defer tax payment on any realized gain from an involuntary conversion, the taxpayer must use the proceeds to purchase qualified replacement property, including repairs. The replacement property must generally serve a similar or related purpose as the converted property. Unlike “like kind,” which applies to tax-free exchanges, “similar use” pertains to how the taxpayer uses the property, constituting a functional test.

An undeveloped lot is not personal use real estate, but a newly acquired lot improved within the replacement period would qualify. A previously acquired lot that is built on after the event will not qualify, but the new construction will. Converting a residence into rental property immediately after purchase does not qualify. Aside from these restrictions, as long as the real estate functions for personal use, it usually meets the standard for lost personal use real estate.

The taxpayer isn’t required to use the actual cash received from the insurance recovery. In fact, it’s acceptable for the taxpayer to borrow funds to complete the reinvestment and invest the insurance proceeds in the stock market if they wish.

Multiple Replacements for Single Loss

For real estate, it is permitted to acquire more than one replacement property rather than invest the funds in one single replacement property. The multiple replacements may be acquired over a period of time.

13    SALE OF RESIDUAL LAND OR HOLD FOR LATER SALE

Another consideration often arises: the outright sale of the residual damaged property remaining after a casualty event. This raises the issue of potentially deferring gain on the combined insurance and sale proceeds, including the gain from the land sale in the computation of the individual IRC Section 121 $250,000 or joint $500,000 gain exclusion, with any remaining gain eligible for deferral. The level of repairs needed to restore the property to its pre-event condition must be assessed, as it may impact the ability to treat the subsequent land sale as part of a single transaction. There’s no clear threshold where loss severity is deemed insufficient to justify subsequent sale as part of the initial casualty, but guidance from courts and IRS rules on feasibility helps. The key question is the cost of repairs compared to the resulting FMV of the property post-repair. The rules don’t mandate investing in repairs exceeding the property’s resulting value determined before the loss event. For example, damage from a flood caused by a water heater explosion inside the home typically wouldn’t qualify as a major loss, and neither would the insurance proceeds combined with a subsequent home sale qualify for gain deferral.

The following example demonstrates the difference in outcomes where the sale of the integral property is split over two transactions and where it is combined as one involuntary conversion transaction for a married couple:

If the sale of land qualifies as part of the original transaction for tax purposes, the gain will be subject to the exclusion benefits and any remaining gain can be deferred.

If there is unused IRC Sec. 121 exclusion remaining at the time of the sale of the lot, it can be applied to the lot sale if the lot sale closes within two years of the date of the loss event.

Proceeds from insurance or lawsuits received more than two years after the date of the loss event still qualify for the IRC Sec. 121 exclusion.

PART 4

14        INSURANCE vs. INCOME TAX

15        THINGS CAN GET WORSE

16        CHANGES AND CORRECTIONS

17        PART PERSONAL USE/PART BUSINESS – IRS Rev. Proc. 2005-14

14    INSURANCE vs. INCOME TAX

The tax benefit rules extend to renters as well. Renters can utilize the tax relief provisions for lost personal property and additional living expenses covered by renters’ insurance policies.

Income tax deductions are not a substitute for filing an insurance claim. If no insurance claim is submitted for a loss covered by insurance, a tax deduction cannot be claimed for the loss as a substitute. In most cases, insurance is not required to be purchased as a prerequisite to reporting a loss on a tax return. A loss may still exist after considering the insurance coverage that may be allowed as an income tax deduction.

The reporting of damages to an insurance company is not the same as the income tax reporting. The insurance company does not have any right to see how the insured reports the outcome on a tax return. They only have a right to see documentation that directly affects the claim of loss. The IRS has the right to see all relevant documentation which may include some or all of the insurance documentation.

Insurance reimbursement typically reflects the value of the lost property, often measured by replacement cost. Proof of ownership is essential for reimbursement, focusing on the item’s original cost and pre-loss value for tax purposes. While replacement cost may be considered, it’s not directly relevant for income tax assessments.

Some insurance deductibles can be reported as miscellaneous itemized deductions for casualty losses.

15    THINGS CAN GET WORSE

Taxpayers may find their situation worsened by both their own decisions and unforeseen events beyond their control. These factors can complicate matters further, adding to the challenges they face in the aftermath of a loss.

Not Reporting a Gain

What happens if the proceeds or reinvestment are not reported to the IRS? According to the law, if no reporting is submitted to the IRS, it assumes that if a gain has been realized, a decision to defer the gain and make a qualified replacement has been elected and will be completed within the required period. However, the statute requires formally reporting the election to defer the gain on an amended return, assuming you did not report a gain when you were supposed to on the original federal or state tax return the year the gain was first realized to the IRS for it to expire with the normal passage of time. Failure to meet this requirement means the IRS retains the ability to examine the applicable returns indefinitely. If a reinvestment is not made, then a tax liability along with penalties and interest hang over the head of the taxpayer.

A 2001 IRS position poses a problem for taxpayers who fail to report a gain from an involuntary conversion. If the taxpayer does make the reinvestment, but does not report the results to the IRS, any acquisitions or repairs can be excluded by the IRS as qualified replacements upon audit.

In its 2001 position, the IRS draws a distinction between the deferral and reinvestment transactions. The deferral is automatic without reporting, but the IRS emphasizes that a reinvestment must be reported in the tax return for the year it occurs to meet qualified reinvestment rules. This means that a taxpayer who is unaware of these rules and makes an unreported deferral decision risks penalties, as the reinvestment is not recognized by the IRS. Consequently, the statute of limitations remains open indefinitely, although the replacement period closes based on the statute.

In a 2012 ruling, the IRS diverged from this position. The distinctions were: In the 2001 ruling, the property in question was a commercial/investment property, and the IRS highlighted the taxpayer’s access to competent professional tax advisers. Conversely, in the 2012 case, the taxpayer was a homeowner who had followed all procedures correctly, except for reporting to the IRS. In this instance, the IRS granted leniency to the homeowner.

Temporary Or Permanent Residence

In certain cases, taxpayers may opt to acquire a temporary residence following an event making their primary residence uninhabitable or while dealing with a prolonged settlement process. This raises the question: What’s the best course of action? One potential solution involves purchasing a temporary home with the intention of selling it once the primary residence is restored. However, if a resolution isn’t reached in due time, the temporary home could become the permanent replacement. How does one navigate this situation when faced with the obligation to file annual tax returns? Each year requires a decision: Is the acquired home intended as a temporary measure or a permanent replacement? Accurate reporting remains a priority and the treatment of the temporary home within the replacement plan may significantly impact tax responsibilities. Let’s consider various scenarios.

Purchasing Temporary Home – Does Not Become Permanent Residence

If the home is not declared as part of the permanent replacement plan, then no portion of the deferred gain is allocated to the purchase reducing the cost basis. The taxpayer can deduct the mortgage interest and property taxes. Any tax impact from the sale may be minimal or absent. If the home value does go up and the home is held for at least 2 years, then the gain may be eliminated by the IRC Section 121 exclusion.

Purchasing Temporary Home – Becomes Permanent Residence

If the temporary home is not declared as part of the replacement, and it turns out to be the permanent replacement due to a change in circumstances, the deferred gain has no asset to be attached to and it will become taxable.

Purchasing Temporary Home – Becomes Part of the Replacement Plan

If the temporary home is declared as part of the replacement plan, deferred gain will be subtracted from the cost basis. Keeping in mind that the gain may have been reduced by the IRC Section 121 exclusion, up to $500,000 may already be excluded. If the taxpayer does acquire an actual permanent replacement home or repairs the damaged home (within the required replacement period restrictions), then the deferred gain can be allocated to both the temporary and permanent homes on a proportional basis related to the value of each, not necessarily the time of acquisition.

The recovery process should involve careful planning on how to move forward. It’s essential for the taxpayer to consider how to protect their family while making rational decisions that account for all potential situations.

Not Reporting a Loss

In tax law, there’s a concept known as “Allowed or Allowable.” This concept impacts individuals who choose not to report a loss. Essentially, a loss is allowed to be deducted for losses that genuinely occur. However, if the loss is not claimed, the IRS has the authority to assert that it should have been claimed. This means that the non-recognized loss is assumed to have been claimed, even though the taxpayer did not receive the tax benefit. Consequently, when the property is eventually sold, the IRS reduces its cost basis to reflect the loss that wasn’t initially claimed.

Death and divorce present unique challenges when they happen after a catastrophic event but before the completion of the recovery process. The main concern is that any gain obtained by a taxpayer are tied to that individual. Consequently, the deferred gain cannot be transferred to another taxpayer for the purpose of completing a replacement. Instead, it must be addressed by the taxpayer who initially realized the gain.

Death of an Owner

If a taxpayer passes away after the event, they are no longer available to complete the reinvestment, resulting in taxes being owed on any gain realized prior to their death that was not reinvested, according to a 1964 ruling. This stance has been challenged in court multiple times, with the IRS losing in every case. The ruling remains in effect. When the surviving members of the taxpayers’ families fought this ruling in court, their success was based on the argument that the families were carrying out the plans of the deceased taxpayer.

Divorce

Divorce can lead to significant tax implications, particularly if it occurs during the replacement period or if the consequences aren’t considered beforehand. In a straightforward scenario involving a gain from a residence, a potential solution could involve each party receiving half of the proceeds and making separate qualifying reinvestments. However, what if the assets lost are business assets belonging to one spouse? Consider a situation where a husband operates a machine shop, and a fire destroys all the equipment. The wife has no involvement in the business, which was operated as a sole proprietorship and reported on their joint tax return. Since they reside in a community property state like California, each spouse is considered to own half of the business for tax purposes and thus realizes half of any gain. If a divorce occurs during the replacement period, the wife is deemed to have realized half of the gain and is liable for the corresponding tax or reinvestment. Consequently, she must remain engaged until the replacement is finalized, at which point all community property can be fairly allocated between the divorcing parties.

16    CHANGES AND CORRECTIONS

What if the taxpayer simply has a change of mind regarding a prior reporting decision? Some decisions are reversible, and some are not.

 Not Going to Reinvest After Making Election to Reinvest Proceeds

• “I don’t want to rebuild or reinvest. I’ll just pay the tax on the gain.”

The taxpayer must wait until the end of the reinvestment period, file an amended return for the year the election was made, and pay the tax. The IRS will bill for interest, but not underpayment penalties.

Once you’ve opted to replace the lost property and defer the gain, reversing this decision is only possible if the replacement period expires without completing the replacement commitment.  Unfortunately, this necessitates filing an amended tax return years later, along with paying the tax and interest owed.

Taxpayer Decides to Reinvest After Tax Has Been Paid on a Gain

• “I paid the tax on the gain, but now I want to reinvest.”

If a taxpayer initially reports a gain in the year they receive the proceeds, but later determines that deferral would be a more beneficial choice, the law permits the taxpayer to reverse their decision. In such cases, the taxpayer can file an amended return, settle the tax and interest owed, and fulfill the necessary reinvestment requirements. It’s important to note that the reinvestment still needs to be completed within the specified reinvestment period, determined by the date when the proceeds initially generated a gain.

Recovering a Prior Loss Due to Additional Proceeds Received

• “I originally reported a loss, but then I received more money, so now I have a gain.”

Sometimes, a taxpayer initially receives insufficient funds to cover the loss and claims a loss on their tax return, but receives more compensation, such as an insurance or lawsuit payment, later. These additional proceeds must be assessed cumulatively. If there’s a reversal of the prior loss deduction, it must be reported as income in the year the additional proceeds are received, limited to the lower of either the deduction benefit of the prior loss deduction or the additional proceeds received. This income resulting from the loss reversal is categorized as ordinary income in the year received, not capital gain. If the previous loss is entirely offset, resulting in a gain, that gain may be deferred. The replacement period clock, usually two or four years, starts ticking at the end of the year in which the gain is realized.

17    PART PERSONAL USE/PART BUSINESS – IRS Rev. Proc. 2005-14

Mixed Use Properties and Partial Use of Section 121

Mixed use refers to property that serves both business and personal purposes. The business component could be a part of the main residence structure or situated in a separate building on the property. The Section 121 gain exclusion, mentioned earlier, is applicable to mixed-use real estate. These exclusion rules are applied with both restrictions and flexibility. On the restrictive side, the IRS imposes limitations on what qualifies as a primary residence and transactional restrictions.

In cases of an involuntary conversion of a primary personal residence where part of the home is used for business purposes, such as renting out a room or using a room for business, the gain on the portion used for business qualifies for exclusion. However, if the business use property is a separate structure from the main residence, a cost allocation must be conducted. In such cases, the gain on the business portion does not qualify for the exclusion, but may be eligible for deferral if repaired or replaced with other business property.

If, at the time of the catastrophe, the taxpayer has met all the Section 121 requirements, except that the property was owned and occupied less than two years as a personal residence, relief is provided. The taxpayer may prorate the exclusion for the period that the qualification has been met. If, for example, 18 months of the two years’ requirements have been met then, 75% (18 divided by 24) of the exclusion may be used. In such a case, if the gain is less than $375,000 (75% of $500,000), the taxpayers will be able to exclude all of the gain.

PART 5

18         EFFECTS OF CHANGING USE AFTER REPLACEMENT

19         “ALE” – ADDITIONAL LIVING EXPENSE REIMBURSEMENTS

20         EXPERTS –TAX REPORTING

18    EFFECTS OF CHANGING USE AFTER REPLACEMENT

Conversion of Personal Use Real Estate to Rental Property After Rehabilitation

BEFORE: Property was only for personal use

AFTER: Change in use to rental after rebuilding

A qualified replacement has not taken place in this case, because the property was not kept for personal use as it was before the event.

Home Not Re-Occupied, But Not Converted to Other Business or Rental Use

In some cases, the taxpayer may repair the damaged home, but decide not to reinhabit it upon completion of the repairs. Has a qualified replacement taken place?

As long as the property remains a personal residence and isn’t used for business or rental purposes, it meets the necessary requirements. However, selling the home immediately after completing the repairs raises questions about whether the repairs were conducted on a personal residence or a property intended for investment. Any clear intention to convert the property into an investment would pose a problem, as the replacement of the personal residence would not occur in that scenario. There isn’t a definitive regulation or ruling on this matter. Insurance companies may restrict the use of proceeds for purchasing a replacement home without reducing the payout. This could compel taxpayers to complete repairs for the optimal financial outcome. The timing and availability of other financial resources may also influence the taxpayer’s ability to execute such a plan. A taxpayer who wishes to sell the property upon completion should refrain from designating the home as qualified replacement property. Instead, they can complete the repairs, sell the property, and acquire replacement property all within the required replacement period.

19    “ALE” – ADDITIONAL LIVING EXPENSE REIMBURSEMENTS

Additional living expenses (ALE) refer to costs incurred beyond the normal expenses of food, shelter, and commuting prior to the event. These additional expenses are not considered part of the catastrophic loss, and there is no provision in the tax law to deduct them, however, most residential property casualty insurance policies include coverage for reimbursing policyholders for these additional expenses. These proceeds are not taxed if they are used to pay qualified additional living expenses. However, any unspent funds become taxable as ordinary income in the year that the taxpayer no longer incurs additional living expenses.

The question is regularly asked:

“The insurance company is willing to pay me $3,000 a month rent reimbursement for 12 months. What if I take a lump sum of $36,000 and use that to invest in a mobile home or use the money to make a down payment on a temporary home?”

Funds used to acquire an asset such as a mobile home or to purchase a home are not expenses, they are investments. The money used in this manner is taxable.

Another situation:

The taxpayer already owns a rental home. The insurance company’s additional living expense proceeds are used to reimburse the taxpayers for rent on their own rental home, used as temporary housing.

The taxpayer must treat the insurance money as ordinary income and loses the depreciation and some other deductions that are only attributable to a rental.

20   EXPERTS – TAX REPORTING

Homeowners may hire experts to assist in the recovery. Categories these costs can fall into:

1. Proving and documenting the insurance claim of loss
2. Rebuild/Repair/Replace Expenditures
3. Tax Reporting Compliance

The major expenses likely to be incurred during the recovery process include the following:

• Public Adjusters that assist the homeowner in negotiation of insurance claim
• Attorney fees as an intermediary or part of a legal action
• Appraisers
• Engineers/Geologists
• Architects/General Contractors
• Accountants

The general classifications of proceeds that can arise out of the settlement/recovery process can include the following:

• Payment for property damage (home, personal property, vehicles and boats).
• Payment for additional living expenses
• Payment for medical expenses
• Payment for burial costs
• Payment for other personal injuries, physical or non-physical, including bad faith

Payments to consultant/expert to document the amount of the loss proving the loss are an offset to applicable proceeds received, including payments to an attorney as a result of settling legal action related to the property settlement. Payments to a general contractor repairing the damaged property are part of the reinvestment. An engineer’s report that was originally prepared for settlement of the claim, but is later used by the architect to design the replacement/repair, is also part of the replacement costs.

Assume the following:

A lawyer is hired for 30% of the gross proceeds out of the proceeds received. The action is successful and the proceeds are paid as follows:

The tax accounting would be as follows:

Personal injury and punitive damages will be part of AGI, so a minimum of $24,000 (2% of $600,000 x 2) will reduce the miscellaneous itemized deduction. For years 2018-2025, miscellaneous itemized deductions are generally not allowed.

PART 6

21         LAWSUITS

22         MORTGAGE INTEREST

23         IRS AUDITS – GOOD FAITH REPORTING

21    LAWSUITS

In certain cases, individuals who suffer a catastrophic loss may find it necessary to take legal action against their insurance company, contractor, or third party believed to be at fault for the casualty, to ensure proper performance. This process typically concludes with either a settlement or a court decision, resulting in the homeowner either succeeding or failing in their action. According to the law, when the suing party prevails, the costs, including attorney fees, are treated as a collection expense. If the plaintiff is unsuccessful, they cannot deduct the legal costs incurred. The tax treatment of these expenses is discussed in the preceding section. However, there are special circumstances that may arise, as described below.

Assume a homeowner sues the insurance company for additional money for the actual loss. The suit also includes a claim for acting in bad faith during the claim settlement process. The way the suit is structured can affect the manner in which it is treated for tax reporting later. The homeowner’s claims in the suit might be as follows:

Contract issues – additional money for actual damages to real and personal property:

$250,000 demand

Bad faith:

$1,000,000 demand

The suit settles for $350,000. The insurance company refuses to allocate the total proceeds between contract and bad faith issues. Generally, the IRS breaks up settlements based on the corresponding percentages of the total damage claim. In this situation, 20% of the total damage claim of $1,250,000 was for contract issues, therefore only $70,000 (20% of the settlement) is treated as that part of the settlement, with the remaining $280,000 allocated to settlement of the bad faith claim. This result is a major problem for the homeowner. The $70,000 less any attorney fees (approximately $21,000, 30%) can be used to make replacements to the home and defer or eliminate any tax consequences. The $280,000 is all taxable, and related legal costs are only a miscellaneous itemized deduction. The net proceeds after state and federal taxes as high as 50% on the $280,000, less deduction for attorney fees of at least 30% might be as little as $56,000, a total of approximately $105,000 for the whole settlement.

An alternative claim would have only a $300,000 claim for bad faith. This would make it 54.5% of the total damage claim, which would be $190,750 of the $350,000 settlement, leaving $159,250 for the contract issues.

Proceeds from bad faith and psychological trauma caused by the defendant are taxable at ordinary tax rates and are not subject to deferral. The attorney fees related to the settlements of bad faith and psychological trauma claims are not offset against the proceeds; they are reported as miscellaneous itemized deductions, whose tax benefits are often lost due to adjustments that will come into the computation.

22    MORTGAGE INTEREST

If, during the repair or rebuilding process of the home damaged in the catastrophic event, the property remains unoccupied, the interest on the mortgage remains deductible to the extent it was deductible prior to the event. This deduction applies as long as the taxpayer can show that the property is intended to remain a qualified personal residence or is being held for sale.

When the taxpayer obtains temporary housing through a mortgage, the interest on that mortgage may also qualify for deduction. However, the total deductible interest cannot exceed the amount defined as qualified home mortgage interest. Typically, this is capped at the interest on total debt not exceeding $750,000 of mortgage debt. Additionally, no more than two personal use residences may be combined for this calculation.

If the damaged real estate turns into investment property, the investment interest deduction limitation would govern the deductibility of the interest.

23    IRS AUDITS – GOOD FAITH REPORTING

The United States tax system is considered a voluntary compliance system. Tax collectors don’t come to our door and go through our records each year to determine the tax liability. We prepare a return and pay any tax due or request a refund for overpaid taxes. On occasion, after a return has been filed the IRS or state income tax authority may request additional information to substantiate or clarify a position, or resolve a reporting discrepancy.

When taxpayers who have acted in good faith and made reasonable determinations in their return preparation face changes in their returns, they typically result in additional tax and interest assessments. However, significant underpayments trigger penalties mandated by law. If the tax authority finds an unreasonable or unsupported position taken to avoid tax payment, additional substantial penalties may be imposed. Notably, erroneous disaster loss deductions leading to significant tax return adjustments can automatically trigger additional penalties.

Due to the substantial sums typically involved in insurance claim settlements and disaster losses, it’s vital to ensure that reporting proceeds on tax returns complies with both documentation and legal standards. Tax preparers should be thoroughly briefed on payment specifics and other relevant figures. Overestimations and unreasonable allocations or descriptions may prompt audit adjustments, leading to significant costs and penalties.

Certain items may flag the IRS’s attention independently or through random selection. Adequate explanation on the return regarding substantial casualty loss claims can sometimes suffice without further IRS inquiry. However, insufficient disclosure may prompt requests for additional information and investigation for inconsistencies. This area demands expertise and is unsuitable for the inexperienced.

PART 7

24         TAX CODE PROVISIONS AVAILABLE FOR TAXPAYERS IN FEDERAL DISASTER AREAS

25         BUSINESS AND INVESTMENT LOSSES DISASTER LOSSES

24    TAX CODE PROVISIONS AVAILABLE FOR TAXPAYERS IN FEDERAL DISASTER AREAS

The federal government may determine that an incident qualifies as a federal disaster area. Generally, these are major losses. People who experience a federal disaster are able to realize financial and tax benefits provided by various agencies of the federal government.

The income tax benefits are different for those who realize a gain and those who realize a loss.

In most federal disasters, federal tax filing, compliance, and enforcement deadlines for matters unrelated to the loss are deferred under IRC Section 7508A.

An Order to Demolish

If an order to demolish the remaining improvements is issued within 120 days of a disaster event, and it would increase the loss, it can be included as part of the original loss. This is particularly beneficial if the demolition order occurs in a year subsequent to the original loss.

Non-Itemizers

For taxpayers who don’t itemize deductions on Schedule A of Form 1040, Congress passed legislation that allows these taxpayers to add to their standard deduction the net amount of the disaster casualty loss.

Gains (Involuntary Conversions)

The tax on the gain can be deferred just as it can be deferred for non-disasters with additional benefits.

Personal Property (Contents)

Assessing contents in non-disaster situations can be challenging, with catastrophes like fires complicating data gathering for gain or loss determination. In federally declared disasters, insurance proceeds for personal property linked to primary residences are exempt from reporting, eliminating the need for gain computation. Taxpayers can still claim a loss if insurance proceeds fall short of the adjusted cost basis of lost personal property.

Qualified Replacement Property for Real Property and Scheduled Property – Primary Residence – in a Federally Declared Disaster

The proceeds received for the personal use primary home structure and scheduled personal property are considered a common pool of funds that may be reinvested in otherwise qualified replacement real property, defined as personal use land and structure as well as scheduled property. General household contents also qualify for inclusion in this amount.

As scheduled property is specifically listed in the insurance policy, the law assumes that the taxpayer has access to all relevant data about these items, similar to the cost basis of the home. However, the challenge arises because taxpayers usually store this vital data in the home that is destroyed in the loss event.

25    BUSINESS AND INVESTMENT LOSSES DISASTER LOSSES

The provisions outlined above for primary personal residence losses also apply to losses of business and investment properties in federally declared disasters. The rules for replacement business property are applied somewhat differently than those for personal use real estate. In the case of business and investment property, qualified replacement property is defined as: “Tangible property of a type held for productive use in a trade or business.”

If you’ve lost business property in a disaster, you’re allowed to replace it with any other business property. This represents an extension of the standard replacement rules, and applies to investment property, enabling the replacement of investment property with business property. However, if the taxpayer prefers to replace the investment property with another investment property, they would follow the general rules accordingly. The replacement period for both business and investment property remains two years.

If you would like more information or if you have experienced an event and want assistance with your loss reporting, please contact John Trapani, CPA.