2012 YEAR-END RECOVERY TAX CONSIDERATIONS
Before I get into the details,, keep your mind on the health of your family, physically and emotionally. That is your first “job” in any recovery process. Tax issues are important, but keeping your family together and as “unscathed” as you can is the most important item on your recovery process list.
Some of the suggestions listed below may involve interaction with your insurance company. BE CAREFUL, don’t jeopardize your negotiations in order to take advantage of a tax tactic listed below. These suggestions need t be considered in context of the whole situation.
LOSSES vs. GAINS
Yes, the idea of a gain is always a tough concept to accept when a taxpayer is thinking about the fact that a beloved home has been totally destroyed by a catastrophic event. But, if you expect to receive insurance proceeds or similar compensation that exceeds the cost basis of the property lost, you have a gain. (see item number 4 in Part 1 of the “Process of Recovery”)
Tax savings for this year may be important to conserve assets to pay for recovery and unreimbursed event loses and substitute lost income. But, over the past several years I have seen returns prepared by other many other tax professionals who either “empathetically” or ignorance, generated losses in the year of the event that had to be recovered later due to additional reimbursements that should have been considered at the time the original tax return was filed. The outcomes can be terrible. See past entries for case studies:
“PERILS OF DISASTER TAX REPORTING ERROR” 7-6-2012, and
“DON’T RUSH TO DEDUCT” 9-12-2011
By recovery of a loss referred to above, that means if you claim a loss and then receive total proceeds in excess of the amount that you used to compute a loss, then that additional recovery will be taxable regardless of any other decisions that you have available to you regarding the total proceeds. That means the proceeds will be added to your other taxable income.
But you may actually have incurred a tax deductible loss.
Then the question is how do you compute the loss?
For now the main two issues you have to tie down are the cost basis of the assets you lost or were damaged and the insurance reimbursements (or similar proceeds) that you will receive, not just what you receive as of the end of this year.
Insurance is relatively simple. But cost basis will likely take some time to compute. Now is probably not the best time to compute the cost basis, there is no good time. But now is better than a month from now. Your memory will not be better in a month. In fact it will be worse.
Lost your record? Try the real estate broker you worked with, maybe the escrow or tax attorney who assisted in the transaction. Check with your county recorder, they may have information about your purchase. The title insurance company may also have information that you can use. Of course that does not take into consideration all the modifications that you made over the years. When it happened to me, I still had a structure to look at. Check with friend and relatives, they may have photos of your home. Imagine each room, look around, what got added or changed. Did you remodel a kitchen? Call the contractor for a copy of the records that the contractor has. Keep in mind that the contractor may not have all the records. If you paid for permits or architectural fees directly, you will need to get those records separately.
For many losses, you will need an appraisal. For real estate the appraisal needs to be prepared by a competent real estate appraiser, for personal property the rules are a bit less strict. A couch you purchased at a retail store is not likely to be worth appraising, the cost would be excessive. The IRS would like you to use thrift store values. The courts do not agree with the IRS on this point. Keep in mind, before the loss event you had no intention to donate the couch, so it must have been worth more than that value. For items that are worth more than $5,000 before the loss event, an outside valuation should be sought. There are personal property appraisers; most of them specialize, jewelry, antiques, art works, autos. Make a list of the high value items that you lost. Which items, though damaged, are still in existence? Those items are available to the appraiser. The tough ones are those that are at the bottom of a pile of rubble that is being picked up and carted away? The assets that were not only damaged but also physically lost will be tougher for the appraiser. How does the appraiser know that you owned it? Do you have photos? Do your friends and relative have photos of your property? Now is the time to gather as much evidence as you can. Photograph the damaged property. Photos are better than videos, yes a video may be better in demonstrating the situation, but you can’t put it in a book or report.
Here are three prior postings to check out:
“Why is the Cost of Repairs Method of Loss Valuation not the one to use?” 5/27/2011
“LOSS VALUATION COST OF REPAIRS METHOD” 7/16/2008
“FIGURING THE LOSS – MARKET VALUE METHOD” 6/18/2008
LEGAL ACTIONS – FILING DEADLINES
If you are considering a lawsuit in connection with your loss, check with a knowledgeable attorney who has experience in the field to determine your rights and how time may be eroding those rights.
CLAIMING THE LOSS ON THIS YEAR’S TAX RETURN OR AMENDING LAST YEAR’S RETURN TO CLAIM THE LOSS
See another blog entry:
“DON'T MISS THE APRIL 17TH DEADLINE TO FILE AND AMENDED RETURN” 3/30/2012
Keep in; mind that the filing date for 2012 individual returns will be April 15, 2013, a Monday.
If the ultimate proceeds you will receive are expected to exceed the cost basis of your property you will have a gain.
WHAT TO DO?
Just because you have a gain does not mean you will have a tax to pay. That does not mean that you have taxable income due to the gain.
The tax code provides a clear method for not paying tax on the gain.
To avoid tax on the gain, all you have to do is reinvest the proceeds in a manner that is consistent with the characteristics of the property you lost. Keep track of the proceeds. Report the proceeds and make the election on your tax return to reinvest them.
For primary personal residence losses taxpayers have at least four years to complete the reinvestment if the loss event was declared a federal disaster. (See other blog entries for declared disaster areas.) Additionally, if the home was completely destroy, as defined by the IRS, you may be able to eliminate up to $500,000 of the gain from any tax considerations
But, although it is clear and relatively easy to avoid paying any tax on the proceeds, that does not mean that you cannot mess up.
Don’t make this mistake:
“The IRS does not know I have received this money.
“I will not receive a Form 1099 from the insurance company.”
While it is true that you probably will not receive a Form 1099, the IRS could come back to you in 5, 10 or 15 years and find the fact that you had not reported the funds and assess tax, penalties and a lot of interest. It could wipe you out. With compliance comes peace of mind.
Here is another false reasoning:
“The IRS regulations provide that if I don’t report the proceeds, it is ‘assumed’ that I have reinvested the proceeds.”
Well, that is almost true. The tax code assumes that if you don’t report that you have made an election to reinvest the proceeds in the correct type of property, the tax code does assume you have made an election to replace. But, if you don’t actually report the reinvestment the IRS assumes you did not make the reinvestment. That means the proceeds are taxable. If you do make the reinvestment, and you do report the reinvestment according to the rules, you have to go back and report the election to replace the property to the IRS in a timely filed amended tax return.
It really is not worth messing with this. On audit, how are you going to explain those large deposits into your financial accounts? It is much easier to simply follow the rules.
The worst situation you can have is one where you receive proceeds and in the same year you spend them on repairs or a replacement, and you don’t report the transactions. You have been assumed to have made a replacement election, but the proceeds that you spent on repairs will not be counted as a qualified reinvestment. In other words, the proceeds that you spent on repairs are considered taxable.
Form more bad news, see the IRS document: Field Service Advice (FSA) 200147053.
EXPECTATION OF ADDITIONAL PROCEEDS
If you are expecting a loss, don’t underestimate the proceeds that you expect will be received. See above comments.
If you are expecting a “gain” situation, but your proceeds this year are less than your cost basis, that is okay. Simple report the facts and elect the replacement option, note that you are expecting additional proceeds in the future. If it turns out that you don’t receive the additional proceeds and you end up with a loss, you can go back and deduct the loss on an amended return for the year of the loss event.
ESTIMATED TAX PAYMENTS WHEN YOU HAVE DECIDED TO PAY TAXES ON THE GAIN
Here is an easy way to save money. If you have not paid your estimated taxes this year because you believe your taxable income is going to be lower, check your assumptions. It may not go down like you expected. If you decide not to reinvest all the insurance proceeds and have a gain, then you could be exposing yourself to big penalties. Check with a knowledgeable tax professional.
ACCELERATING CLAIMS PROCESS OR SLOWING THE CLAIMS PROCESS AS THE END OF THE YEAR APPROACHES
Here are a couple of scenarios to consider:
If proceeds you receive between now and the end of the year cumulatively will exceed your cost basis, remember that the limitation on you replacement period whether it is a two year or t=four year period, it will start as of the end of the year in which you first receive cumulative proceeds that exceed your cost basis. If that “$50,000” payment is received before the end of the year you will have two or four years from the end of the year to replace the property. But if the “$50,000” payment is received after the first of the year, then you will have an additional year to replace the property. This concept does not work if you decide not to open the mail box to take out the check, or if you tell the insurance company to hold the money that they want to send you today. That is a problem. The IRS takes the position that if you have what is called “constructive receipt” of the funds, then, you are “charged” with having received them. But if you are negotiating a payment, you may not want to push for receipt before the end of the year.
If you plan on reporting a gain as taxable income because you will not be reinvesting all of the proceeds, then you may want to accelerate the payment into 2012. See:
“NEW TAXES FOR 2013 COULD AFFECT YOUR DECISIONS” 9/17/2012
If you expect a loss, it does not make any difference if you receive proceeds prior to the end of the year.
ADDIONAL LIVING EXPENSE FUNDS
Additional living expense (ALE) proceeds are not taxable if they are spent on actual additional living costs. What if you receive a check in December for January rent on your temporary home? That is okay.
What if you are at the end of your replacement process? Keep in mind that cumulative funds you receive in excess of the costs you expend are taxable. But they do not become taxable until you have completed your need for spending additional costs of living. Therefore if you are in this position and you finish your need for the additional living support in 2013, then the excess will be taxable in 2013.
Your questions are always welcome. There is a lot to consider.
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.
Certified Public Accountant
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Thousand Oaks, CA 91362
(805) 497-4411 E-mail John@TrapaniCPA.com
It All Adds Up For You
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.
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© 2012, John Trapani, CPA,