If this is your first year preparing returns for clients with casualty gain/loss, you may be a bit overwhelmed (I know we certainly were in 2017 when we had hundreds of clients lose their homes). We put together this guide to help you navigate the process. This tax situation is governed mainly by IRC 1033.
Let’s say that Chris and Pat owned a home in Santa Cruz. The home was their personal residence and had no business use. They did not make any improvements to the home. The home was destroyed in a fire in August 2020. The fire was declared a Presidential disaster.
Step 1: Determine the basis for the gain/loss Calculation.
- C&P purchased the house for $450,000 in 2012. They made no improvements.
- Determine the Fair Market Value of the property before the disaster and the Fair Market Value of the property after the disaster. The IRS wants appraisals for these figures. In our case, C&P had an appraisal on the property right before the fire due to a refinance. So, the FMV of the property before the fire was $700,000. The Fair Market Value of the property after the fire is $200,000 (the value of the land).
- Next, determine the smaller of the basis in the property or the Change in Fair Market Value (in our practice over the past few years the basis has always been smaller than the change in FMV).
- Basis: $450,000
- Reduction in FMV: $700,000 – $200,000 = $500,000
- The smaller of those two figures is $450,000.
Step 2: Determine the insurance reimbursement
- The insurance company will provide a summary sheet showing the insurance proceeds by type of coverage. In our case Chris and Pat received $600,000 of insurance for the dwelling and $300,000 of insurance proceeds for contents (aka personal property). The insurance checks were received in October 2020.
Step 3: Determine the gain/loss
- For the home the gain is $600,000 – $450,000 cost basis = $150,000 gain on the casualty. The gain is realized in 2020 because they received the check from the insurance company in 2020.
- For the personal property, no gain is recognized for insurance proceeds for unscheduled personal property in a federally declared disaster. So, C&P get the $300k of contents insurance tax-free. (1033(h)(1)(A)(i))
Step 4: What do do with the gain?
- C&P have a few options. Since they lived in the home as their personal residence for 2 of the past 5 years they qualify for the Sec 121 homeowner’s exclusion. So they can exclude up to $500,000 of gain.
- Also, since the fire qualifies as a casualty they can defer paying tax on the gain if they reinvest the insurance proceeds into a new home (1033)(a)(2)). They can do this by buying a new home or rebuilding their home on their lot and using all the proceeds within the prescribed timeframes.
- Or, if their gain had been bigger, they can use both meaning they could exclude $500k of gain using Sec 121 and then the rest of the gain can be deferred using 1033 (See our article about using both of those here.)
- Since this was a personal residence in a Presidentially-declared disaster, the property has to be replaced within 4 years from the end of the tax year when gain was realized (1033(h)(1)(B)). C&P received the insurance check in 2020 so their gain year is 2020. They have 4 years from 12/31/2020 to replace the property.
Step 5: How to report on the tax return?
- If you want to exclude using Sec 121 you just don’t report the gain on the tax return (unless you received a 1099-S).
- If you want to exclude using Sec 1033 then you just don’t report the gain on the tax return, However we recommend you attach an election statement because this reminds the tax preparer that you have to be sure the taxpayer reinvests the proceeds in the appropriate timeframes to qualify for the 1033 deferral. Then once the property has been replaced, attach another statement showing the replacement property and the gain deferral calculation.