Casualty loss

[leezee3]

Client had their apartment, they rented destroyed by fire in 2006. Most of the personal items were destroyed by fire. They did not have renters insurance but because the apartment building was not upto the safety code(non working fire alarm) they were able to settle and receive money from Apartments insurance.

They did not claim any loss on their 2006 return and now the Apartment lawyers have issued them a 1099-Misc box 3 for the amount of settlement.
They money they received was greater than the cost basis of the items destoryed

My questions
1. Can I go back and amend 2006 return to take the loss which could be substantial and include the reimbursement in the income in 07 to the extent the deduction reduced tax in 2006.

or

2. Report a gain in 2007 for the difference

I have never done a return with casualty loss. Any help appreciated
Thanks

[Jesse]

Read TTB 4-22
2. If insurance reimbursement is more than the basis in the property destroyed, the reimbursement is a gain. The gain is taxable if a taxpayer does not use the proceeds to purchase replacement property.