Casualty Gains

If you receive insurance reimbursement that is more than your adjusted basis in the destroyed or damaged property, you may actually have a gain as a result of the casualty or theft. However, the fact that a gain exists does not necessarily mean that it will be taxable right away. You will probably be able to defer the gain to a later year (or perhaps indefinitely) if you purchase qualified replacement property.

First, in calculating your gain, remember that you can subtract from your reimbursement any expenses you incurred in obtaining the reimbursement, such as the expenses of hiring an independent insurance adjuster.

Then, if you spend the same amount as the remainder of the insurance money you received, either repairing or restoring the property, or in purchasing replacement property, you can postpone tax on the gain. However, you must make the replacement within two years of the end of the tax year in which you have the gain. If the loss was to your main home, and the area was declared a federal disaster area, you have more time: up to four years after the end of your tax year in which you have the gain.

The replacement property must be similar or related in use to the property that was destroyed. For instance, if your car was destroyed, you can replace it with another car, but not with a piano. If your home was destroyed, you can replace it with another main residence such as a home or a condo, but not with a store building. If the property was investment real estate, then other investment real estate will qualify as a replacement, but not a second home. However, if the property was business or income-producing property located in a federally-declared disaster area, any business-use property will qualify.

You cannot postpone a casualty gain of more than $100,000 by purchasing replacement property from a related party, such as a corporation you control.

However, you can replace property and defer gain by purchasing a controlling interest in a corporation that owns similar property, as long as you own at least 80 percent of the stock.

If you purchase replacement property, you will have to reduce the tax basis of the new property to reflect the casualty gain you postponed.

Example Daisy Tandy, an avid car collector, purchased a 1948 Packard convertible in poor condition at a garage sale for $1,000. After months of hard work and an additional $5,000 in car parts, she managed to restore most of the car's majesty, not to mention its chrome. To protect her labor of love and her investment, she insured the car for $25,000, with a $500 deductible. After a freak auto accident involving her neighbor's fence, Miss Daisy's car was totaled. Her insurance company reimbursed her in the amount of $24,500 ($25,000 less the $500 deductible). So, Miss Daisy had $18,500 ($24,500 minus the $1,000 purchase price and $5,000 in upgrades) of realized gain on the involuntary conversion of the property. Miss Daisy spent the entire $24,500 of insurance proceeds on a replacement car and thereby qualified for a deferral of tax on all her gain. Her basis in the replacement car is $6,000, the cost of her new car reduced by the amount of her unrecognized gain ($24,500-$18,500=$6,000). If she had spent less than the full amount of insurance proceeds she received, any amount between $6,000 (the original cost of the car plus restoration costs) and $24,500 would be recognized as taxable gain.