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By Grover A. Cleveland and
Wayne R. Wells

Certainly, the casualty loss of a personal residence is a devastating event in the lives of those experiencing it. From a tax standpoint, however, the loss will be less devastating if it is caused by a catastrophe that ultimately becomes a presidentially declared disaster.

General Rules For Casualty Cases

Absent a presidentially declared disaster, the tax consequences of the destruction of, or damage to, a personal residence and its contents are covered under IRC Sec. 1001, which provides that any payment from an insurance company is considered an amount realized. If the amount realized exceeds the taxpayer's adjusted basis (amount invested) in the property, the taxpayer has a taxable gain. If the payment is less than the taxpayer's basis, the taxpayer has a casualty loss, deductible under IRC Sec. 165 as an itemized deduction, subject to the following limitations: 1. The first $100 of loss is not deductible for each occurrence, and

2. The remaining amount of nonbusiness casualty loss must be reduced by 10% of the taxpayer's adjusted gross income.

The term payment includes those reimbursements made for the property and its contents and excludes payment for temporary living expenses, car rentals, restaurant expenses, or similar items.

IRC Sec. 1033 permits taxpayers to elect to defer the tax on any gain realized from the disaster if certain conditions are satisfied. The proceeds must be invested in "similar use property." In practice, this has come to mean that the property must have the same functional use as the property being replaced. As such, a principal personal residence would have to be replaced with another principal personal residence, and personal use property must be replaced with similar use personal property.

The replacement property must be acquired within two years from the end of the year in which the gain was realized. The regulations authorize an extension of the time to make the replacement if the IRS accepts the reason for the delay [Reg. Sec. 1.1033(a)-2(c)(3)].

Finally, the gain can be deferred only to the extent the taxpayer spends an amount equal to, or greater than, that received as a payment for property. Therefore, the taxpayer must demonstrate that an amount at least equal to the insurance proceeds was spent on a replacement residence and its contents. Finally, the property acquired must be purchased. Acquisition of property by gift or inheritance does not qualify as replacement

The regulations require the taxpayer to disclose, in the year that the gain is realized, all of the details relating to the replacement [Reg. Sec. 1.1033(a)-2(c)(2)]. If the details are not disclosed because the replacement has not occurred at the time of the filing of the return, an election to defer the gain will be deemed to have been made if no gain is reported. If it becomes apparent that some of the gain should have been taxed in an earlier tax year, an amended return should be filed.

IRS Pub. 547 provides the details on the required election statement when the replacement property is acquired in a year other than the year in which the gain is realized.

Example. Assume Pat's house, with an adjusted basis $95,000, was destroyed by a hurricane. The contents, with a basis of $40,000, were also destroyed. The insurance company paid Pat $120,000 for the residence and $45,000 for the contents, resulting in a realized gain of $25,000 on the house and $5,000 on the contents. Within two years of the event, Pat spent $130,000 in purchasing a new principal residence and $50,000 replacing her personal property. Pat can make the election to defer the realized gain. If the election is made, the basis of the new residence would be $105,000 ($130,000 purchase price­$25,000 of deferred gain) and $45,000 in the new personal property ($50,000­$5,000 deferred gain). If Pat spent only $105,000 on a new residence and $40,000 on the contents, she would have a taxable gain of $15,000 on the house (the amount of the gain not reinvested in a replacement residence) and $5,000 on the contents.

It should be noted that establishing the basis of the house is usually quite easy but establishing the basis of the contents is often much more difficult.

Presidentially Declared Disaster

The President of the U.S. may declare a calamity a "presidentially declared disaster" if there is an emergency or major disaster that requires Federal assistance to supplement state and local efforts to save lives, protect property, or lessen the threat of catastrophe [42 U.S.C. S5170(1)]. A major disaster is defined as, "any natural catastrophe (including any hurricane, tornado, storm, high water, wind-driven water, tidal wave, tsunami, earthquake, volcanic eruption, landslide, mudslide, snowstorm, or drought), or, regardless of cause, any fire, flood, or explosion in any part of the U.S. which in the determination of the President causes damage of sufficient severity and magnitude to warrant major disaster assistance to supplement the efforts and available resources of states, local governments, and disaster relief organizations in alleviating the damage, loss, hardship, or suffering caused thereby" [42 U.S.C. S5170(2)].

If a personal residence loss is caused by such a presidentially declared disaster, significant tax advantages are available to the affected taxpayer.

Special Rules For Presidentially Declared Disaster

IRC Sec. 1033(h), effective for property involuntarily converted on or after September 1, 1991, modifies the general tax treatment of such casualty losses by easing the rules on the replacement of personal property and extending the overall replacement period.

Recently issued Rev. Rule 95-22 clarifies the application of the provision of Sec. 1033(h). Insurance proceeds are generally divided into two types, those for unscheduled personal property and those for scheduled property and the principal residence. Scheduled property could include things like art works, coins, jewelry, etc., that are specifically covered by the insurance policy.

IRC Sec. 1033(h) provides that for unscheduled personal property, no gain shall be recognized because of the receipt of insurance proceeds, regardless of how the proceeds are used. This provision permits the taxpayer to ignore having to determine the basis of personal property destroyed or damaged, and keep track of amounts spent on replacement property. This applies even if little or none of the proceeds are spent on replacement personal property. Scheduled property would not qualify for this related treatment.

The new provision treats proceeds received for the residence and scheduled contents as proceeds for a single item of property. The proceeds would be treated as a "common pool" of funds from which the taxpayer would only recognize gains to the extent the funds received exceed the cost of appropriate replacement property. Additionally, Rev. Rul. 95-22 makes it clear that the replacement property could be either scheduled personal property or the replacement residence in any proportion.

Example. The new provisions would have the following affect on the previous example of the destruction of Pat's house and contents: Assume again that Pat was paid $120,000 for her house and $45,000 for its contents by her insurance company for damages caused by a hurricane that became a presidentially declared disaster. Again, assume her basis in the house was $95,000 and her basis in the property was $40,000. However, $5000 of the $45,000 was paid for the destruction of scheduled property with a basis of $4,000. The new provision would allow her to treat $125,000 ($120,000 for the house and $5,000 for the scheduled property) with a basis of $99,000 ($95,000 plus $4,000) as a "common pool" of funds. If she spends at least $125,000 on a replacement residence and similar use scheduled property, she would have no taxable gain. If she spends $118,000 on both types of property, she would have a taxable gain of $7,000 ($125,000­ $118,000).

As to the $40,000 insurance proceeds received for unscheduled property, she would have no taxable gain, regardless of what she does with the proceeds.

IRC Sec. 1033(h) also extends the time to replace the destroyed or damaged property, real or personal, from two years to four years from the end of the year in which the gain is realized.

Although relatively rare, it is important for tax practitioners to be aware of the special treatment provided by IRC Sec. 1033(h) in those situations that have been severe enough to result in a presidentially declared disaster instead of a mere regular disaster.

For those taxpayers fortunate enough to have their principal personal residence and contents damaged or destroyed by a presidentially declared disaster, IRC Sec. 1033(h) provides for less potential taxable gain, lessened reporting requirements, and a significantly longer replacement period for both the structure and its contents. *

Grover A. Cleveland, DBA, CPA is an associate professor of accounting at Metropolitan State University.
Wayne R. Wells, JD, LLM, is a professor of taxation and business law at St. Cloud State University.

Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editor:
Richard M. Barth, CPA

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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