Wednesday, June 18, 2008


Figuring the Loss - Market Value Method

The tax law provides two methods for computing a deductible loss in the event of a casualty event. The “Cost of Repairs Method” and the “Market Value Approach.” This entry only deals with the “Market Value Approach.”

If there is insurance covering the loss and the insurance proceeds exceed (or are expect to exceed) the “cost basis” of the lost property, then for income tax purposes, there is no loss and there is a “gain” that is covered under the involuntary conversion rules as a deferred gain or under the casualty loss rules as a “sale” of a “capital asset.”

If there is no insurance, or the insurance does not cover the recovery of the “cost basis,” then there might be a loss.

Use of the “Market Value Approach” requires that there be appraisals by qualified appraisers of the fair market value (FMV) just prior to the event and just after the event. The difference between the two values is the loss, unless that is greater than the “cost basis” after deducting any insurance proceeds from the “cost basis.”

Most people assume that the deduction amount will be the cost of restoring the property to its condition prior to the loss less the insurance proceeds. This belief is even reinforced by the Internal Revenue Service positions warning that including drops in economic values due to the general deterioration in values in the affected area due to buyer resistance are not part of the loss. Insurance is purchased to return the damaged property to its pre-event condition; that is not necessarily an absolute indicator of the loss in value.

Cost of repairs is an important consideration in the process, but making a determination of the amount of the loss is not a simple task. For tax purposes, you must be able to support your deductions and thus you need to determine the actual estimated market values before and after the loss. In order to get these values, it is important to have access to the right experts and information. If you have an expectation of a large deductible loss, you will need to hire a qualified real estate appraiser. Most important to this process is that the appraiser be knowledgeable about the applicable IRS rules that apply to these special situations. A standard appraisal prepared for a refinancing or a sale may not be adequate.

Additionally, the IRS will often accept an appraisal prepared for an SBA loan application related to the recovery from the event. This will only cover the post-event value. You will need one for the pre-event value also.

Additionally, the valuation process that is used for tax purposes is not identical to that required for insurance claim purposes. For tax purposes the drop in values is the determining factor. For insurance purposes, the issue is bringing the property back to its pre-event condition; value is usually not a major part of the insurance determination process.

For smaller losses, where the $1,500 or more price tag for the appraisal may be prohibitive, you might ask a real estate broker to assist you in gathering information on comparable properties' market values before and after the loss. Additionally, the realtor may be able to suggest the amount of the adjustment for the general economic decline related to the disaster area (buyers’ resistance that is not part of the loss) and differences in the qualities of the properties used for the comparison. But keep in mind that a realtor is not an appraiser. An appraiser may be a realtor.

Where the loss is part of a large, widespread disaster, where substantially all homes in the area have been lost, comparables may be impossible to determine. Realtor’s and appraisers archives may be useful. You will be developing the estimated costs of repairs using other experts. If this is the way you are going to proceed, keep in mind that the database that real estate brokers use may only go back six months in time from the date of inquiry into the system. More history may be available, but require more effort to access. Therefore, much of the "before" data may disappear before you have had the opportunity to access it. Newspapers sometimes report sales prices for properties sold periodically. Old issues may be useful. In some instances, sales that closed up to four months, or even longer, after the loss, may be based on prices that were negotiated prior to the disaster. These subsequent sales may thus not be indicative of post-loss conditions.

While the difference between the two appraisals (limited to the “cost basis”) is the foundation for the computation of the loss in these situations, the IRS will look to the actual cost of repairs as a comparison for the reasonableness of the valuations; but that comparison does not change the method to the “cost of repair method.”

You will also need some way of determining the extent of damage to the sold properties that you are using for comparisons, whether the post-loss sales were based on "as-is" condition, repair of only cosmetic damage, or a full structural restoration to pre-loss quality. This may be very difficult to ascertain. It may be worthwhile for you to visit open houses in your neighborhood. Where that is possible, or where there are any properties being sold on the perimeter of the loss area these properties should be documented in your file. Gather sales materials, ask questions and note status of properties for future reference – take pictures where possible. You may have to justify your own information as well as be able to refute IRS information.

Remember if you deduct a casualty loss on your year of loss tax return, it is not likely that it will be reviewed for audit until sometime after a year later. Your detail notes and pictures of comparable homes may be very valuable data if you are audited. Before you make any decisions, discuss your individual facts with a tax professional. There are too many variables involved and the dollar amounts are too large for you to depend on conclusions reached based solely on a neighbor's situation to be your basis of any decision in the recovery process.

The cost of appraisals is not part of the casualty loss. These expenses are deductible as “Miscellaneous Itemized Deductions” on Schedule A of Form 1040 for personal losses and as business expense for trade of business losses and rental property losses.

There are limitations as to the deductibility of personal casualty losses that will affect the decision and the outcome of the loss analysis.

Thursday, June 12, 2008

Should You Buy a Replacement Home?

 Should You Buy a Replacement Home?

Many people who have experienced a disaster consider alternatives to spending a year or more reconstructing their home. One alternative that I am often asked about is the tax implications of selling the damaged home "as is" and purchasing a “replacement” home. This is allowed for in the tax code.

There are several issues that must be considered:
1. $250,000 / $500,000 exclusion of gain on the sale of a personal residence,
2. New IRS requirement that to use the exclusion of gain on the sale of a personal residence the disaster event must have “completely destroyed” the home,
3. The amount of the combined proceeds from the insurance proceeds and net sale of home and the resulting “gain” or “loss,”
4. Resulting amount of total proceeds that must be reinvested in a replacement home and qualified personal property (contents).
5. The ability to transfer (California) Prop 13 assessed value to replacement home.

The key factors that are involved are:
1. The amount of insurance proceeds received and anticipated to be received,
2. The value of the home after the disaster on the open market,
3. The extent of damage to the property, and
4. Lender limitations.

If the property was only damaged a small amount, this solution may not be available due to depressed market values and limited insurance proceeds. Additionally, the assessor may not be able to transfer the pre-event assessed value to the replacement home.

In 2007 the IRS issued a ruling from the Office of the Chief Counsel (OCC) stating that the use of $250,000 / $500,000 exclusion of gain from the sale of a qualifying personal residence would not apply in disaster situations unless the home was “completely destroyed.” An outright sale would seem to be excluded from the OCC ruling, but the calculations could get complicated.

If the $250,000 / $500,000 exclusion does apply, it is deducted from the gross proceeds first to the extent of any gain. The remaining receipt or anticipation of the receipt of insurance proceeds and proceeds from the sale are applied to reduce the cost basis of the damaged property. This will often eliminate any cost basis and create a “gain.” The gain is deferred if an election is made under code section 1033.

The $250,000 / $500,000 exclusion availability amounts depend on ownership and occupancy as well as marital status and the prior use of the exclusion within two years of the disaster.

The sale proceeds for the damaged home are usually combined with the insurance proceeds to create one reportable transaction. These transactions may occur in two or more tax years. The reporting is accomplished on interim reports that tell the story, but do not report any taxable income or loss.

The way it works is that the sale of the house can be considered part of the overall disaster process proceeds. Thus, the receipt of the insurance proceeds and the proceeds from the sale of the house are considered one economic event. The house is reported as the sale of a personal residence at a price equal to the insurance proceeds plus the proceeds from the actual sale of the house. The total gain (after applying the $250,000 / $500,000 exclusion, if applicable) is deferred. The taxpayers have four years from the end of the first year in which a gain was realized to acquire a replacement home and qualified personal property (contents).

In some circumstances, the four years can be extended if the IRS has approved a longer time in individual cases after an appropriate application for additional time has been received in a timely manner.

In most cases the lender holding the mortgage on the damaged home will be listed as a joint payee on any insurance checks and sale proceeds. Therefore, the lender will either need to cooperate or be paid off before any proceeds can be used to purchase a replacement home.

If the lender is to be paid off with the insurance proceeds, the taxpayer will have to secure a new loan on the replacement property. Due to the disaster, the taxpayers’ credit status may have been impacted. The market for new loans in the disaster area may be non-existent. These elements will have an effect on the taxpayers’ ability to carry out the desired plan.

In order to avoid any potential tax, the price paid for the replacement home and contents must equal at least the total of the insurance proceeds and the net sales price received for the damaged home (net of the $250,000 / $500,000 exclusion). The $250,000 / $500,000 exclusion may become an issue as to how the transactions are dealt with if the “completely destroyed” qualification is not satisfied. The IRS has not provided any qualifying assistance regarding the meaning of “completely destroyed” such as more than X% damaged. Therefore, we must assume that it is uninhabitable and beyond repair. The municipality may or may not have condemned it. Visual documentation and repair analyses of physical and monetary loss should be kept as part of your tax records.

Wednesday, June 4, 2008


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Since June 4, 2008, I have added additional important content. In addition to this article, you are referred to:

Friday, October 7, 2011 “THE PROCESS OF RECOVERY – POR”

The process of understanding all the issues that arise in the process of recovering from an individual casualty event or one that is considered to be a “disaster” can be daunting. Such a process exists regardless of the event being declared a disaster by the Governor or the President. The tax related issues alone involve many areas of tax law that taxpayers do not deal with on a day-to-day basis. These tax laws become very complex even though they were written, mostly, to reduce the otherwise onerous impact the tax laws would have on taxpayers in these situations.

The law is basically divided into two areas, “casualty losses” and “involuntary conversions.” Two taxpayers may find that one of them is covered by the casualty loss rules while the other is covered by the involuntary conversion rules, after the same event. The difference usually centers around the presence of adequate insurance proceeds being paid to the person(s) having experienced the event. Casualty losses are events where there is no compensation or the compensation is less than the costs previously invested by the taxpayer(s) in the property lost. Involuntary conversions result when taxpayer(s) have been or expect to be compensated for their loss in excess of their “sunk” costs in the assets lost.

The list below itemizes important issues for casualty of involuntary conversion events that should be considered. It is not exhaustive, but will start you on the road to asking the questions that are specific to your situation in such situations.

In the work that the firm does assisting individuals and businesses in the process of recovering from a disastrous event, we cover these issues initially and throughout the recovery process. Issues not listed may also arise in some situations.


a. Income Tax Reporting
Review and “revisit” tax returns for the three years prior the year of the event. Discuss the possible correction of previously filed tax returns, net operating loss carrybacks and carryforwards may affect these returns. If you have lost the returns in the event, call the tax preparer for a copy or using IRS Form 4506, available from the IRS website,, to request old returns.

b. Insured Losses
Computing estimated “gains,” determining the amount deferrable from current tax recognition.
Reporting part or all of the “gain.”
Effect of purchasing personal property to absorb deferred taxable “gain” resulting from the receipt of insurance process for structural damage.
Period of time in which reinvestment must be made - qualifying for an extension of time to complete the reinvestment.
What qualifies as a reinvestment?
Taxation of insurance proceeds for Additional Living Expenses (ALE).
What is deductible as miscellaneous itemized deductions instead of as a casualty loss?
Tax treatment of fees paid to public adjusters.
Defining cost basis of destroyed property.
Tax effects of various SBA loans and FEMA assistance.
Possible deduction of actual loss in excess of insurance reimbursement - the "deductible" portion of insurance, problems of low tax basis and high economic losses incurred.
Interest deduction for remaining vacant land.

c. Experts
How do you treat the expenses paid for experts and advisers who assist in the recovery process - Engineering reports, scope of loss, public adjusters, lawyers, therapists, tax advisers, etc.?

d. Additional Living Expenses and Reimbursements
What is deductible?
What is reportable as taxable income?

e. Property tax issues
Tax reductions while property is being rebuild?
What about ‘moving’ your California Prop 13 tax basis to another residence,
What is replacement tax basis?

f. Court Settlements
“Bad faith” proceeds, additional contractually settled proceeds, punitive damages, treatment of legal fees paid to collect proceeds.
Interest included in court awards.

g. Restoration and Repair
Building up your cost basis
Interest deduction during the restoration process.

h. Business and Non-primary Personal Residence
Disaster “losses and gains.”
Differences from primary personal residence situations.
Allocations, when required, if a business was also operated from the destroyed home.

i. IRS audits
What are the areas that seem to be of most concern to the IRS at this time?

j. Sale of Residence -- Income Tax and Property Tax Aspects
Realized gains vs. recognized gains.
After restoration, or "as is," foreclosure, $250,000/$500,000 exclusion, property tax saving possibilities:
Buying a replacement home.
Use and need for appraisals.
When do you combine the receipts from insurance and the sale of the destroyed home for purposes of reinvesting amounts in a replacement residence?
IRS requirement that personal residence mus be completely destroyed to use $250,000 / $500,000 gain exclusion.
Allocation of basis when purchasing personal property and other residential property to “absorb” realized gain.
Replacing old residence with more than one replacement residence

k. Settlement of any lawsuits -- Income Tax Consequences
These additional amounts may have income tax liabilities over and above any direct settlement amounts received in connection with the claims related to the collection of contractual amounts properly due under the insurance contract.
Additionally, some legal fees paid may have harsh tax results.

l. Death of a Spouse
Tax effects of a death of a person who has deferred gain prior to the full reinvestment of the potentially taxable proceeds.

This blog, “” has been addressing taxpayer income tax issues related to catastrophic losses for five years
All rights to reproduce or quote any part of the chapter in any other publication are reserved by the author. Republication rights limited by the publisher of the book in which this chapter appears also apply.


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This material was contributed by John Trapani. A Certified Public Accountant who has assisted taxpayers since 1976, in analyzing and reporting transactions of the type covered in this material.  
Internal Revenue Service Circular 230 Disclosure
This is a general discussion of tax law. The application of the law to specific facts may involve aspects that are not identical to the situations presented in this material. Relying on this material does not qualify as tax advice for purpose of mounting a defense of a tax position with the taxing authorities
The analysis of the tax consequences of any event is based on tax laws in effect at the time of the event.
This material was completed on the date of the posting
© 2008, John Trapani, CPA,