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What??? I Have to Pay Taxes on My Insurance Settlement?

IRS Section 1033 Elections

By Dena M. Cruz, Esq.
Published: November, 2017

The three largest fires in the Wine Country- the Tubbs, Atlas and Nuns fires- burned more than 182,000 acres in Sonoma and Napa counties. It is estimated that no less than 8,400 buildings were destroyed or damaged and sadly at least 43 people lost their lives. The recent fires are expected to generate thousands of personal and commercial claims for insurers.

What caused the fire is still unclear. What is clear, however, is that labor costs, a serious shortage of available licensed contractors, a shortage of housing for workers, insurance uncertainties and safety concerns may delay or drive up the cost of rebuilding. Fear of targeted enforcement by ICE will further exacerbate the problem as undocumented immigrants make up approximately 21% of California's construction workforce. Fire Victims should take note that any delay in rebuilding or finding replacement property, unfortunately, may also trigger capital gains taxes.1

Capital Gains

IRC Section 1001(a) provides generally that gain or loss realized from the sale or other disposition of property must be recognized. As a practical matter, gain is usually limited to appreciating assets like residential or commercial real estate and art. Most personal assets, such as cars and boats, decline in value over time.

Insurance proceeds from property losses are gains to the extent the proceeds exceed the adjusted basis in the property. Taxpayers can, however, defer any gain by complying with the rules in IRC Section 1033.

Involuntary Conversion: Insurance Proceeds.

Insurance is the most common way to be reimbursed for a casualty loss. The following items are also considered “Reimbursements” for tax purposes:

  • The forgiven part of a Federal Disaster Loan under the Disaster Relief and Emergency Assistance Act
  • The repayment and the cost of repairs by the person who leases the taxpayer's property
  • Court awards for damages for a casualty (the amount collected minus lawyers' fees and other necessary expenses)

As stated above, the gain realized must be recognized as income for tax purposes, unless the taxpayer elects to defer recognition. To postpone all of the gain on destroyed or partially destroyed property, the taxpayer must:

  • Elect Non-Recognition, and
  • Timely purchase qualified Replacement Property

Partial Involuntary Conversions

If the property was only partially destroyed- say, for instance, a winery lost its vineyards and cellars but not the tasting rooms- the owner may decide to sell the remainder of the property and relocate elsewhere. In such an instance, any gain on the sale of the remaining property may be deferred if the proceeds are reinvested in eligible property and the following conditions are met:

  • The involuntarily converted property cannot be reasonably or adequately replaced.
  • There must be a substantial economic relationship between the destroyed property and the property sold so that together they constitute an “economic unit.”

In the example above, since the loss of the vineyards and cellars renders the operation of the remaining buildings as a winery “economically impractical,” the property owner may sell the remaining buildings and land as part of the original involuntary conversion and defer capital gain from the building sale as well.2

Electing Non-Recognition of Gain

Non-recognition of gain can be either mandatory or elective depending upon the circumstances. As stated above, if the taxpayer receives insurance proceeds, he has an option under Section 1033 to elect to defer the gain, if any, on the conversion.

An owner elects non-recognition of gain on an involuntary conversion by not reporting the gain on the return for the first year in which gain is realized. To take advantage of the deferral, however, all of the details of the conversion, including description of the property, date and type of conversion, computation of gain, decision to replace, etc., must be reported in a statement attached to the return for each year in which gain is realized.3 The statement should also include the amount of insurance proceeds reinvested on a yearly basis.

If notification of replacement or notification of no replacement is not attached to the taxpayer's return for the taxable year or years in which replacement occurs, each year in which gain is realized is open indefinitely for the assessment of a deficiency.

An election may be changed or revoked if:

  • The taxpayer does not replace the lost property within the required time period,
  • The replacement property is at a cost lower than anticipated at the time of the election; or
  • If the taxpayer elects not to replace the converted property.

The Replacement Period Timeline

Whenever a property is involuntarily converted (destroyed in the fire), it must be replaced within a specific timeline with a property of equal value in order to receive complete tax-deferral. This is called the “Replacement Period.” The type of property, and its use at the time of conversion, are important factors in determining how long a taxpayer has to acquire a replacement property, as well as the specific kind of property that must be acquired in order to defer any gain.

For destroyed property, the Replacement Period begins on the date of destruction. The Replacement Period ends:

  • Unless within the categories below, two years after the close of the first tax year in which any part of the gain on the conversion is realized.4
  • Four Years after the close of the first year in which any part of the gain on the conversion is realized if the property is a principal residence and the loss is deemed a Presidentially Declared Disaster.5
  • At the end of any extension, authorized by the IRS.6 High market value or scarcity of replacement property is usually not sufficient reason for an extension.

Who May Make the Replacement?

The taxpayer that realized the gain is the taxpayer that must make the election. A partnership (which would include a LLC) must make the election. Partners cannot make the election.7 This is so even where a partnership dissolved for state law purposes.8 A partnership-level election is also required where title to partnership property has been left in an individual partner's name, but the partnership is the true owner.9

A corporation, trust or estate must also make its own election. Shareholders and beneficiaries may not elect for the corporation, trust or estate. IRC § 381 (c)(13) permits certain successor corporations to replace the corporate predecessor. If the corporation is in liquidation following the involuntary conversion, the replacement must occur before the liquidation is complete. Note, however, that the replacement of property by an affiliate of a legal entity (for example, a parent corporation), will not satisfy IRC § 1033.10

Qualifying Replacement Property

Replacement Property must be acquired from an unrelated person (i) if the taxpayer is a C corporation, (ii) a partnership in which one or more C corporations own, directly or indirectly, more than 50% of the capital interest, or profits interest, in such partnership at the time of the loss; and (iii) any other taxpayer, if, with respect to the lost property during the taxable year, the aggregate of the amount of realized gain on the property exceeds $100,000.

To qualify as replacement property after the fire, the Replacement Property must be “similar or related in service or use” to the converted property.11 To be “similar or related in service or use, the replacement property must be “substantially similar.”

Examples of Allowed “Substantially Similar” Replacement Property

  • One building replacing two buildings used for the same purpose.
  • Planting new crop or the purchase of standing or harvested crop replacing standing crop.
  • Improved rental property replacing unimproved land subject to a construction contract.
  • The replacement of leased farm property for urban rental property.12 Note, if the property that has been destroyed in the fire is a leasehold interest, then the lessee's use of the property is not determinative for purposes of the like-kind requirement under Section 1033. Rather, the determination of whether or not the replacement property constitutes like-kind property will be based on the similarity of the lessor's interest in the property, in such characteristics as the management and tenant requirements.13
  • Replacement of the destroyed premises on leased land in one location by construction of similar facilities on leased land in another location.
  • The replacement of industrial and agricultural property condemned by the government with improvements (new storm drain, water system, road grading) on the taxpayer's remaining land.14

Examples of Dis-Allowed Replacement Property

  • Improved real property replacing unimproved real property.
  • The replacement of an interest in a Real Estate Investment Trust (REIT) for leased commercial property.
  • The replacement of a shopping center with undeveloped land.
  • The reduction of mortgage debt on similar property owned by the taxpayer.
  • The replacement of container-bound citrus trees for real estate on which the taxpayer planted citrus trees.15

Additional Special Rules Under §1033

The rules under IRC §1033 for deferment of gain on involuntary conversions are significantly easier to complete than other types of exchanges, including 1031 exchanges. For instance, unlike 1031 exchanges, the Replacement timelines can be extended. This may be accomplished by filing an application for extension with the appropriate district director before the end of the deadline. The taxpayer's excuse for needing an extension must, however, be reasonable. Scarcity of available replacement property may not be sufficient!

There also does not appear to be any requirement under IRC §1033 that the insurance proceeds be reinvested directly into the replacement property. Unlike exchanges under Section 1031, it appears that in an involuntary conversion under IRC §1033 only requires the acquisition of Replacement Property be only of equal or greater value. This should allow equity received from the original conversion to be offset with new debt on any Replacement Property.

Unlike like-kind exchanges under 1031, a taxpayer can acquire a replacement property outside the United States for converted property located inside the United States. There is no prohibition contained in the statute as currently written.

Finally, the replacement property standards of IRC §1033 are met by acquiring at least eighty percent (80%) of all outstanding voting stock of a corporation that owns similar, qualifying real estate.23

Deferred Gain

By deferring the gain, the taxpayer will receive the same basis in the new property that it had in the old property. Under Sec. 1033(b)(1)(A), if the taxpayer purchases qualified property for less than the sale proceeds received from the involuntary conversion, the portion of the gain that was not reinvested will be taxed in the year of conversion.

Under Sec. 1033(b), the taxpayer's basis in the new property will be its basis in the old property plus the portion of the gain that was already taxed and any additional cash paid or liabilities assumed when acquiring the new property.

It is important to note that, when the taxpayer eventually sells the property, the deferred gain and any subsequent additional gain will be taxed.

Additional Tax Rules for Loss of Property in Federally Declared Disaster Areas

A disaster loss is a loss that is attributable to a casualty occurring in an area that the President declares a disaster area entitled to federal assistance. FEMA maintains an updated listing of the disaster declarations by year on their website: https://www.fema.gov/disasters/grid/year. On October 10, 2017, a Major Disaster Declaration was declared for the California Wildfires (DR-4344).

There are a number of special tax relief provisions available to victims of a federally declared disaster. Many provide favorable tax treatment of payments received to help people who were negatively impacted by the disaster.

Exchanges under Section 1033

Under Code Sec. 1033(h), a taxpayer whose principal residence or contents is compulsorily or involuntarily converted due to a federal disaster is entitled to the following tax breaks:

  • The time period within which replacement property must be obtained to postpone recognition of gain is extended from two years to four years after the close of the first tax year in which any gain is recognized, unless extended by IRS upon application by the taxpayer.
  • No gain is recognized upon receipt of insurance proceeds for personal property contents which are not scheduled property for insurance purposes. (Section 1033(h)(1)(A)(i).) Unscheduled property consists of all items not itemized on the homeowner's insurance policy.
  • This means that the proceeds do not have to be re-invested in order to postpone recognition of gain. However, the law does not change the provisions for calculating a casualty or disaster loss. The taxpayer must make a rough calculation to see if the proceeds create a gain or loss, and document the result. If a loss occurs, this special rule will not apply.

    Example: The insurance company reimburses the taxpayer a flat amount for spoilage of food stored in refrigerators and freezers due to the fire. The taxpayer/policyholder is not required to itemize the spoiled food or file a claim. The taxpayer recognize no gain if the reimbursement exceeds the original cost of the food.

  • Insurance proceeds for the residence and any scheduled personal property may be lumped together and treated as conversion of a single item of property. This treatment effectively allows taxpayers to replace their home and contents with items of their choosing, not restricting them to replacing artwork with artwork or dining room furniture with similar furniture. In fact, taxpayers can use the artwork or other scheduled property proceeds to replace or rebuild their home.

    Example: Taxpayer's principal residence and all its contents were destroyed as the result of the fires. The destroyed household contents included jewelry and art, each of which was separately scheduled for insurance purposes. The taxpayer received total insurance proceeds of $710,000 as compensation for the destruction of the residence ($700,000) and its scheduled contents ($7,000 for the jewelry and $3,000 for the art). Thus, the common pool of funds is $710,000.

    Within the replacement period for involuntarily converted property, taxpayer spends $700,000 to build a new residence, $40,000 to buy home furnishings and clothing as replacements for those lost in the disaster, and $10,000 to buy a sculpture for her entryway in the new residence. The taxpayer did not replace the jewelry or the lost art. Because she spent $750,000 to buy a replacement residence and contents, which is in excess of the $710,000 common pool of funds that she received, the taxpayer will not be required to recognize any gain upon the loss of the residence and its contents.

  • If a taxpayer's property was held for productive use in a trade or business or for investment and it is located in the disaster area and was lost as a result of the disaster, tangible property of a type held for productive use in a trade or business will be treated for purposes of IRC § 1033 (a) as property similar or related in service or use to the property lost in the fire.

Qualified Disaster Relief Payments

Qualified disaster relief payments (QDRPs) are not included in the recipient's gross income and are not treated as earnings for self-employment tax purposes or as wages or compensation for employment tax purposes.16 QDRPs are amounts paid by the government, a charity or an employer to assist individuals who have been impacted by Hurricane Harvey. QDRPs include:

  • Amounts to reimburse or pay personal, living or funeral expenses incurred as a result of the fires;
  • Amounts to reimburse or pay for repair or rehabilitation of a personal residence (including a rented residence) or its contents for damage attributable to the fires;
  • Payments by a common carrier due to death or personal physical injuries resulting from the fires;
  • Amounts paid by a federal, state or local government, or an agency or instrumentality of those governments, in connection with the fires in order to promote the general welfare

Qualified Disaster Mitigation Payments

Qualified disaster mitigation payments are not included in gross income and do not increase the basis of the property for which the payments are made.17 These are payments made pursuant to the Robert T. Stafford Disaster Relief and Emergency Assistance Act or the National Flood Insurance Act to or for the benefit of the owner of any property for hazard mitigation (for example, flood control) with respect to such property. Qualified disaster mitigation payments are made under the following programs:

  • Flood Mitigation Assistance Program (FMA)
  • Pre-Disaster Mitigation Program (PDM)
  • Hazard Mitigation Grant Program (HMGP)

FEMA “Individuals and Households Program” Payments

Under the Individuals and Households Program (IHP), FEMA provides grant payments to individuals for critical expenses and losses not covered by insurance or other reimbursements that are incurred as a result of a federally declared disaster. FEMA makes the following types of payments under the program:

  • Temporary housing assistance to rent a different place to live or a government provided housing unit when rental properties are not available.
  • Repair assistance for homeowners to repair damage from the disaster to their primary residence that is not covered by insurance with the goal of making the damaged home safe, sanitary and functional.
  • Replacement assistance for homeowners to replace their primary residence destroyed in the disaster that is not covered by insurance.
  • Other needs assistance for necessary expenses and serious needs caused by the disaster, such as medical, dental, funeral, personal property, transportation, moving and storage.

Conclusion

Section 1033 involuntary conversions will be of great benefit to the unfortunate taxpayers impacted by the wild fires this year. Rebuilding and replacing lost property will likely take a considerable amount of time. Perhaps, even longer than the four year window allowed for principal residences and the two year window for other types of property.

If you have any concern regarding making the election, the applicability of the tax, requesting a needed exemption and the time you have to replace the lost property, they are advised to speak with competent tax experts or counsel before they file their next return.

  1. One of the first major hurdles in assisting victims of disasters is in determining and documenting what assets were lost or damaged, the original cost and tax basis (if applicable) of those items, and their Fair Market Value. The IRS has a Record Reconstruction page to assist taxpayers with reconstructing their records after a casualty loss is incurred. It can be found at:
    https://www.irs.gov/businesses/small-businesses-self-employed/disaster-assistance-self-study-record-reconstruction
    Additional information on Disaster Assistance and Emergency Relief for Individuals and Businesses may also be found at:
    https://www.irs.gov/businesses/small-businesses-self-employed/disaster-assistance-and-emergency-relief-for-individuals-and-businesses-1
    https://www.irs.gov/pub/irs-pdf/p2194.pdf
  2. Revenue Ruling 59-361, 1959-2 CB 183.
  3. Treas. Reg. §1033(a)-2(c)(2).
  4. IRC § 1033(a)(2)(B).
  5. IRC § 1033(h)(1)(B).
  6. IRC § 1033(a)(2)(B).
  7. Revenue Ruling 66-191, 1966-2 C.B. 300.
  8. Fuchs v. Commissioner, 80 T.C. 506 (1983).
  9. Private Letter Ruling 8006092.
  10. See, Fort Hamilton Manor, Inc. v. CIR (2d Cir. 1971) 445 F.2d 879.
  11. IRC § 1033(a)(1)
  12. Johnson v. CIR (1965) 43 T.C. 736.
  13. Rev. Rul. 71- 41, 1971-1 CB 223 and Loco Realty Co. v. CIR, 306 F2d 207.
  14. See, Davis v. United States (1979) 589 F.2d 446, where the court held that “the improvements were related to the use of the condemned land.”
  15. In Re Mahon, 1998 Bankr. LEXIS 1056
  16. IRC Sec. 139.
  17. IRC Sec. 139(g)(1) and (3).
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