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.