WHAT ARE THE INCOME TAX ISSUES IN THE PROCESS OF RECOVERY FROM A CATASTROPHIC PHYSICAL LOSS?
Income taxes do affect citizens in the recovery process after major physical loss of property. The outline below provides a basic list of those issues. The list concentrates on personal use real estate.
There are many of these issues that also affect business losses and losses affecting properties held for investment. It may look overwhelming, but many of these issues are
“either or,” therefore only part will apply to your situation. That does not mean that it is not daunting. If you are reading this because you have had a loss, your concern should be, “is my tax adviser well versed in this process?” Most are not, why? Because they feel that they will only have one or two clients in their professional life. Find someone who understands and approaches the process with compassion and from a position of competence.
Circumstances / a casualty event has occurred.
(Disaster or other Catastrophe)
This is not the time to differentiate what is a casualty.
Type of loss: complete loss or partial loss
Loss or Gain / Computing the loss or gain
Recognize a gain or defer?
Qualified Replacement property
Tracking the recovery / Reporting
Changes / Circumstances / Change of mind
Complications, Interpretations, Clarifications
Other: Mortgage Interest / Property taxes
1 Tools for Recovery
Digital Camera & a Journal and pen / Personal Resilience
2 Income tax laws affect people who experience a loss
Basic tax laws involved
“All receipts presumed to be taxable”
“All personal expenses, not deductible”
(Unless otherwise excluded or allowed)
Casualty losses / gains and involuntary conversions are
treated as sales – “other dispositions”
“Tax Law Empathy” – Relief Provisions
“REALIZED vs. RECOGNIZED”
3 Insurance vs. Other Support
Grants – for individuals, for businesses
Gifts / Other support
Forgiveness of debt – SBA Loans
4 Cost Basis
Gain – Accumulated cost
Loss – Accumulated cost, adjusted to lower of cost or fair market value
Loss cannot exceed cost basis
Personal use real estate cost basis
“Integral Nature” Rev. Rul. 96-32
Land, Improvements, Landscaping
5 Documenting – A gain or a loss?
Land and structures, personal property
Basic acquisition cost, improvements
Adjustments – decrease in value before event
Valuations (before / after)
Appraisal (& Appraiser)
Cost of Repairs methods
Physical location of items lost
Replacements (Repairs and /or Acquisitions)
Personal property (Contents)
Real Property (Interior, Exterior & Perspective / To elation to Environment)
“Tax Elections,” Decisions and Tax Consequences
POSSIBLE OUTCOMES: 7 A LOSS
8 NO GAIN OR LOSS
9 A GAIN
FIRST STEP SECOND STEP
Cost Basis Determine Preliminary FMV
Analysis is completed by category
Allocation between damaged and undamaged property
Area? / Relative value? / Something else?
6 Tax reporting follows the insurance proceeds
“A” & “B” Structure (including appurtenant structures such as outbuildings, detached garages) trees & landscaping
“C” Contents (Personal property)
“D” Additional Living Expense (ALE, Extra expense)
Special Endorsements &
Vehicles, RV’s, Boats, …
Potential “Net Operating Loss”
Netting all gains and losses
Adjustments: 10% of AGI & $100 / Event
Loss limited to adjusted cost basis.
7 A Loss
When to deduct a loss:
“Sustained = Occurs & Settled”
Vagary of meaning “Settled”
Loss and cost basis reduced by insurance proceeds
Appraisal (& Appraiser) method:
Fair Market Value – Before and immediately after event
Debris & debris removal,
“Cost of Repairs” method
Must still determine FMV before event
Must complete repairs to pre-event status
Scope of loss – Debris removal
Only costs required to return property to its pre-event condition are part of computation
8 No Gain or Loss
No Gain or Loss
Note in return
Cost basis is reduced by insurance proceeds
Cost basis is increased by repair costs
9 A Gain
Conversion into cash
Decision to replace or not to replace
Reporting taxable gain (all or part) & pay tax
Loss later transition to a gain due to additional proceeds
Electing recognition by reporting gain
Capital gain - Schedule D
Compute Gain: Proceeds received less cost basis
Gain realized, Gain excluded, recognized
Possible exclusion of gain ($250,000 / $500,000)
Primary Personal residence CCA 200734021
Complete destruction, Time qualifications,
PART TAXABLE / PART DEFERRED
Gains reported for year or years gain realized.
Post §121 gain and total proceeds exclusion
Decision not to be taken lightly.
Starting with the year of the event
For year or years of loss and receipt of proceeds, and proceeding for each year thereafter, until the transaction is completed or the replacement period (including extensions) has expired report details.
First: Cost basis is replaced, Second: Gain is absorbed
NO PROSCRIBED FORM, INCLUDE IN DISCLOSURE:
Year(s) gain realized
I. D. of property lost and replacement property(ies)
Dates of loss, reinvestment
Election to defer gain under appropriate Code section
Identification of replacement property or repairs
Proceeds received Less Gain excluded = Gain realized
Gain recognized (taxable)
Details of repairs or replacement funds spent
10 TIME PERIOD TO COMPLETE QUALIFIED REPLACEMENTS
Replacement period generally “two years.”
Two important beginning dates:
1. The date of the event. Start of replacement period.
2. The end of the first year in which cumulative insurance proceeds received exceed the cost basis of the property destroyed. Start of two year period.
3. The replacement period is the period starting with the date of the loss event and extending for a period of two years after the end of the first year in which a gain is realized. (Non-disaster)
Insurance may impose additional limitations on completion of repair / reconstruction and may place limits on replacement with other property.
EXTENSIONS OF TIME TO COMPLETE REPLACEMENT
Only an extension of time to complete qualified replacement
Specific request to the IRS must be made
Extensions of only one year at a time are allowed
Code allows the request to be made
“Within a reasonable time after the expiration of the required period of time”
3 copies – 1 returned to taxpayer confirming the request.
Attach a copy to tax return for year of expiration and the year of completing reinvestment.
11 Statute of limitations
All affected years are open until statute runs on the last year.
Ability to start clock running on statute before filing a tax return
Statute of Limitations only starts to run once transactions is reported.
12 “Qualified Replacement Personal Use Property”
Deferral requires replacement.
“Similar or related in service or use”
Functional test / personal use assets
Structure / Contents / Vehicles (RV’s, Trucks, Cars)
Using actual “cash proceeds” or
“new debt” to acquire replacement property…
Either works. (PLR 6104215900A, Rev. Rul. 56-347)
ORDER OF REINVESTMENT
• Replace Original Cost Basis
• Absorb Gain
• Remaining costs increase original basis
• Remaining un-invested proceeds are taxable
MULTIPLE REPLACEMENTS FOR SINGLE LOSS?
• Total all acquisitions
• Allocate gain, pro-rata over the total of all acquisitions
13 Sale of residual land / or hold for later sale
Rev. Rul. 83-50
When is it part of the original event?
Why does it matter?
FEASIBLE TO REPAIR OR NOT FEASIBLE
NOT FEASIBLE TO REPAIR
14 Insurance vs. Income Tax
Insurance reports available to tax examiners
Insurance does not have access to tax returns
Insurance may require different information than income tax
15 What You Can’t Fix
DEFERRED GAIN: FAILURE TO REPORT QUALIFIED REPLACEMENT PROPERTY (IRS REG. §1.1033(a)-2(c)(2) )
Decision is automatically made:
Deemed election to defer the gain
IRS controls replacement
Made with any qualified assets.
– Replacing the original cost basis
– Absorbing the §1033 deferred gain realized.
That is completed within statutory time period.
Taxpayer exerts control, responsibility and
thoughtfulness to the process.
PROPERTIES TAXPAYER DECIDES ARE NOT ACQUIRED AS REPLACEMENT PROPERTIES:
Purchase of temporary home – allocation of deferred gain, pre-mature sale or held for §121 exclusion
A property not included as part of reported replacements cannot later be elected to be included.
Temporary home turns out to be replacement home –has been excluded from being reported as part of the replacement property.
“Not reporting a loss” – “Allowed or allowable”
• Change of mind:
Not going to reinvest: “I deferred gain. I want to pay tax and not rebuild, not reinvest.”
– Must wait until end of statutory replacement period and amend returns for years gain was realized.
• Event is reportable by the person who experienced the loss – a taxpayer who dies before replacement cannot replace the asset.
• If the property was owned by more than one person, such as a husband and wife, each one is responsible for completing their portion of the replacement
16 Changes and “Corrections”
• Change of mind:
“I want to reinvest. I originally reported gain and paid the tax.”
– Amend original returns to “un-recognize” gain reported that is reinvested
• Recovering a prior loss :
“I originally reported a loss and then received additional proceeds.”
– No amended return, report the additional proceeds in year of receipt,
– Recapture prior losses to the extent of prior benefits not to exceed additional proceeds received §111 applies. Recovered loss is ordinary income.
– May elect deferral on gain realized after recapturing loss.
17 Part personal use / part business
Rev Proc 2005-14
Primary personal residence
Other personal use real estate
Under one roof / Separate buildings
Business property – Rental, Other
18 Affect of changing use after replacement
BEFORE: property used for personal use
AFTER: Change in use to rental after rebuilding
Qualified replacement has not taken place
Property was not kept for personal use
Home not re-occupied. But not converted to other use
19 ALE – Additional Living Expense
ALE is paid for living expenses.
Using ALE funds to purchase real property for housing causes the funds to taxable as they were not used for rent.
Tax reporting – Funds not used are taxable in final year ALE is incurred
20 Experts – reporting for tax purposes
1 Proving Claim of Loss
2 Part of Rebuilding Process
Add to Cost of Replacement
3 Part of Tax Compliance
Sch. A, 2% Miscellaneous Itemized Deduction
(Change from 2 to 1: Look to original intent.)
Public Adjusters Attorneys
Engineers, geologists Architects Accountant
21 Law suits, expenses incurred
Successful or unsuccessful
Follows original transaction
Physical injury – Tort – Not taxable
“Bad Faith” & punitive damages non-physical damage tort - Taxable – ordinary rate
22 Mortgage interest
Qualification as continued residential home mortgage interest deduction
Be careful, purchase of temporary housing may cause limits of deductibility to be exceeded
23 IRS audits – good faith reporting
VOLUNTARY TAX CODE COMPLIANCE SYSTEM
Substantiation, reasonable expectations
Audits are from small samples with potential harsh enforcement penalties.
Generally 20/20 hindsight
When to deduct a loss and statute of limitations
Rules affecting examiners on audit - CCA 200750016
24 Property tax issues
Transfer “Prop 13 Basis”
Intra-county and Inter-county
CALIFORENIA DISASTERS PROP 50 & 171
(R&TC Sec 69 & 69.3)
Temporary reduced assessed value
SELLER IS AGE 55 OR MORE PROP 60
(R&TC Sec 69.5) REPLACEMENT PROPERTY
25 Tax Code Provisions Available in Federal Disaster Areas – Primary Residence:
• Disaster Declarations
ALL AFFECTED TAXPAYERS
• §7508A (Rev. Proc. 2007-56)
• Claim on the tax return for year of loss or return for year immediately preceding year of loss
• Order to demolish within 120 days of event
• Number of years to replace is four years not two
• Personal Property (contents) proceeds not reportable
• “Qualified Replacement Property” is expanded.
Primary Home and Scheduled Personal Property Proceeds considered a common pool of funds to be reinvested in Personal Use Land and Structure, Scheduled Property, and General Contents.
The Robert T. Stafford Disaster Relief Act sets out the process and parameters for the federal government’s declaration of a major catastrophe being a “Federal Disaster Area.” People who experience a Federal Disaster are able to realize financial and tax benefits provided by various agencies of the federal government.
The Income Tax benefits are different for those who realize a gain and those who realize a loss; they include the following.
For federal disasters involving a primary personal residence:
ALL AFFECTED TAXPAYERS
Deferral of many federal tax filing, compliance and enforcement due dates under IRC Section 7508A. Rev. Proc. 2007-56
Taxpayers may claim the loss on the tax return for the year of the loss or the return for the year immediately preceding the year of the loss.
This would allow a taxpayer who experienced the actual loss in 2011 to deduct the loss on their 2011 income tax return or on their 2010 return.
If the 2010 return has already been filed, an amended return may be filed.
The amended return must be filed no later than April 15, 2012 for 2011 disaster losses claimed in 2010. (No extensions are permitted.)
An order to demolish within 120 days of event (increasing the loss) can be included in original loss.
The number of years is four years not two year for the reinvestment period.
The tax on the gain can be deferred as for non-disasters. The rules about reinvestment also apply, generally.
Personal property (contents) in non-disasters is the most difficult aspect of a casualty loss in the case of a catastrophe such as a fire that consumes the whole home and everything in it.
In the case of a declared disaster only, the insurance proceeds received for personal property do not have to be reported and no computation, for tax purposes need be determined. This does not preclude a claim for a loss, if the insurance proceeds are less than the adjusted cost basis of the personal property lost.
The definition of what is “Qualified Replacement Property” (QRP) is expanded.
The proceeds received for the personal use primary home structure and scheduled personal property are considered a common pool of funds that may be reinvested in otherwise replacement qualified real property such as personal use land and structure as well as scheduled property, but also general contents.