Many victims of the California wildfires have been surprised to learn that they have a gain on the loss of their rental property in the California wildfires.  When you lose your rental in a sudden and unexpected event like a wildfire, it is called a casualty.  If the amount of money you received from insurance is more than your adjusted basis of your rental, then you have a gain on the casualty and that gain is taxable.  However, you may be able to exclude that gain using an Involuntary Conversion as defined in I.R.C. § 1033.

Calculating the gain

Gain on the involuntary conversion is the difference between the net payment received and the adjusted basis of the destroyed property. Net payment is generally the insurance payment minus the expense of obtaining the payment. Adjusted basis is generally the original cost plus improvements less depreciation.

Postponing the gain

Part or all of the gain may be postponed if the taxpayer purchases a replacement property of similar use (like another rental) within the replacement period. The replacement period for business property is two years (I.R.C. § 1033(a)(2)(B)(i)). To postpone reporting all of the gain, the replacement property must cost at least as much as the amount realized (I.R.C. § 1033(a)(2)(A)).

Basis in the new property

Your basis in the new property is the same as basis for the converted property (I.R.C. § 1033(b)(1)).

Example: Chris owned a rental in Paradise, CA that was destroyed in the Camp Fire. Chris originally purchased the rental for $100,000, made $50,000 of improvements, and claimed $25,000 of depreciation over time. Chris’ adjusted basis in the rental is $100,000 + $50,000 – $25,000 = $125,000.  Chris received $300,000 from insurance. Chris has a gain on the casualty of $300,000 – $125,000 = $175,000. If Chris uses the money for a vacation, the money is taxable in the year of the casualty. If Chris purchased a new rental in Palm Springs in March of 2019 (within the replacement period) for $300,000, she will meet the requirements of I.R.C. 1033, and is able to defer the gain. Her basis in the new property is $125,000.