Main Home Involuntary Conversion

[rkhan71]

Hello all,

I hope to ask with clarity:

My client was involved in a total fire loss (involuntary conversion) of main home back in late 2015. I am trying to verify and answer my client's concerns. Primarily about insurance proceeds, and the taxation aspects of the situation. She wants to know if not all proceeds are spent on replacement property (or rebuilding), whether the difference is taxable. I say yes, if not all money is reinvested in replacement property or rebuilding, if of lesser value than proceeds. However, I believe, because of the exclusion rule, they may be able to avoid taxation. She also wants to know how is the house treated after having this fire loss and insurance proceeds? Sale of house or just indemnification?

So, there are few elements to the taxation or non-taxation of insurance proceeds of a main home. But my research seems to show that as long as they buy or build with value that is equal to or greater than insurance proceeds, they may not have a problem; with AB considered as part of the calculation and the Section 121 exclusion rule.

Please advise if anyone can add anything that I should be concerned about in advising my client - if they wish to buy at lower price or build at lower value and pocket the difference from insurance proceeds. I would, as always, greatly appreciate a response.

Thanks.

RFK

[Roland Slugg]

There are really two issues here: Is there a taxable gain? Is there a deductible loss?

The A to the first Q depends on the cost of the replacement house, assuming it is purchased during the 2+ year replacement time period. If the replacement house costs at least as much as the amount of the insurance proceeds following the fire, there is no taxable gain. The insurance proceeds themselves don't even gave to be used to pay for the replacement property. All or part of it can be financed with a new loan. If the cost of the replacement property is less than the insurance proceeds, the difference is taxable. However, as you stated the gain can be excluded under §121 if the T/Ps otherwise qualify. It's like the house was sold to the insurance company for the amount received from it.

However, there can also be a casualty loss from a fire. To have a personal (i.e. not business) casualty loss, you use the lower of the asset's basis or its FMV immediately before the casualty, and subtract its value immediately after the casualty. Reduce that loss by the amount of insurance proceeds, and if there is still a loss, it can be deducted, subject to the haircut rules, which are pretty brutal.

[rkhan71]

Thanks Roland

Appreciate the information Roland.

RFK