The answer to this and most tax questions is: It depends. There is a potential for the insurance payments to be taxable and it depends on the facts and circumstances of each case.
Casualty Loss: If a Home Owner was uninsured (or under-insured) and lost their house, they could have a sizable casualty loss. (A casualty loss is taken on your tax return. Starting in 2018, you can only take a loss on your federal return if the disaster was a Federally Declared disaster. For California, you can take a loss for any casualty.)
Casualty Gain: If they were insured and if the insurance award is greater that the home owner’s basis (original purchase price plus improvements) then there is a possible taxable gain. The insurance payment for the loss of the house is considered the Sales Price. Comparing the Sales price to the Basis determines if there is a Taxable Gain.
WAIT, YOU ARE NOT LISTENING. THERE WAS NO SALE.. MY HOUSE WAS DESTROYED IN THE FIRE.
Yes, you are right. It seems unintuitive but this is the way the tax code works. When you get insurance money it is treated like a sale of your property.
Example: If you bought your house for $200,000 and you receive $500,000 in insurance benefits, there is a $300,000 gain.
SO, DO I HAVE TO PAY TAXES ON THAT GAIN?
Luckily, there are two IRS code sections that can reduce or eliminate the gain from the insurance received. Section 121 covers the exclusion of Gain from a Principle Residence and Section 1033 covers Involuntary Conversions which are losses that happen as a result of events such as Fire, Earthquake, Flood, etc.
Using Section 121
Since the destruction of your personal residence is treated as a sale of property, for purposes of the section 121 exclusion if the taxpayer otherwise qualifies (that is, during the five-year period ending on the date of the fire, the home has been owned and used by the taxpayer as their principal residence for two years or more) part of the gain ($250,000 for single taxpayers and $500,000 for married filing jointly taxpayers) may be excluded.
Example: Using the example above, if you have a $300,000 gain but you were single and qualified for the Sec 121 exclusion, then you could exclude $250,000 of the $300,000 gain. Leaving you with a gain of only $50,000.
Using Section 1033
This section allows you to defer recognition of the gain on your tax return assuming the tax payer reinvests the proceeds in a replacement property within defined time limits. Note: This is just a deferral of the gain. The basis of the replacement property is adjusted for the deferred gain and thus when you sell the property, you could recognize the gain at that time. The rules around this are quite complex, thus we have not gone into all the details in this article.
The calculations around the casualty gain or loss are complicated and using the Sec 121 and Sec 1033 exclusions are even more complicated and there are special rules if your loss is due to a federal disaster (such as the Camp, Hill and Woolsey fires) thus we recommend that you consult with your Enrolled Agent or other tax professional when preparing your tax return to ensure you get all the tax benefits you deserve.