INCOME
AND PROPERTY TAXES CONSEQUENSES AND REQUIREMENTS
PART
3
9 A
GAIN
10
TIME PERIOD TO COMPLETE QUALIFIED
REPLACEMENTS
11 STATUTE
OF LIMITATIONS
12 QUALIFIED
REPLACEMENT PROPERTY
13 SALE
OF RESIDUAL LAND / OR HOLD FOR LATER SALE
9 A
GAIN
“CONVERSION INTO CASH”
In order for a gain to arise, the
damaged property must be converted (compensated) into cash or some other
property that is not similar to the property lost. Generally this means
insurance compensation. Additionally, the compensation must exceed the cost
basis of the property damaged. Once a gain arises, two possibilities exist, the
taxpayer can pay the tax or make an election to defer the gain by using the
proceeds to acquire suitable replacement property. This is consistent with the
intent of Congress to return taxpayer to their pre-event condition. If the taxpayer
must pay tax on the gain and then use the remaining cash to replace their
property, they would have difficulty in that pursuit with inadequate resources.
On the other hand, the taxpayer may see
the situation as a way of doing something totally different, paying the tax may
be an acceptable alternative.
Determining a Gain
The process of computing a gain is the
same as described above except that the taxpayer realizes a gain by using
actual cost basis deducted from the insurance proceeds. The gain computation
does not need to reduce the cost basis to a potential lower “adjusted cost
basis,” (Fair Market Value) before event. Completing the computation, an
expected loss may result in a “no gain / no loss” result due to the insurance
proceeds not exceeding the cost basis of the damaged property, but exceeding
the “loss.”
The computation may lead to a gain. For
example, the anticipated insurance proceeds exceed the actual cost basis of the
property. If a “gain” or “no loss” is obvious, there is no need for appraisals.
Once it has been established that there
is a gain, a gain is realized in the year that the actual cash proceeds exceed
the cost basis of the damaged property. A decision must be made whether that
gain will be recognized, reported on a tax return as taxable (essentially
treated as a sale), or reported as an involuntary conversion gain to be
deferred.
WHAT IS AN
INVOLUNTARY CONVERSION?
If insurance and
other similar reimbursements in connection with the destruction of real and
personal property exceed the cost basis of the property lost, a gain has been
realized. Since the transaction was not voluntarily initiated by the party
whose property was lost and there is a gain, it is called an “involuntary
conversion.”
What do you do
with that gain? Once a determination has been made that a gain has been
realized, a number of considerations must be reviewed and decisions must be
made. First, in order for there to be a gain, a transaction must have taken
place that converted property into something of value that is not “similar or
related in service or use to the converted property,” usually this is cash.
Next, that conversion must not have been voluntary. That would be an event
such as a fire, flood, earthquake or some other “casualty event.”
CONVERSION INTO MONEY
In a “like kind exchange” the
rules require the taxpayer to maintain the appearance of not handling any
funds involved in the sale of the property disposed of and those actual funds
are used to acquire the replacement property in order to avoid being taxed on
the cash, otherwise called “boot.”
Involuntary conversions
assume that the taxpayer is in receipt of cash or other property that is not
similar or related in service or use to the converted property. Where the conversion is into dissimilar property the
nonrecognition of gain becomes an option:
… at the election
of the taxpayer the gain shall be recognized only to the extent that the
amount realized upon such conversion (regardless of whether such amount is
received in one or more taxable years) exceeds the cost of such other
property or such stock.
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A number of conditions enter into the
decision including the following, at a minimum:
1. What is the amount of the gain? Is
it so insignificant that recognizing it is the most efficient way to move
forward?
2. Are there any capital losses in the
prior five years that received preferential tax treatment. Those would cause
the recognition of the “casualty gain” to be taxed in an unacceptable manner, at
ordinary income tax rates, not the more favorable capital gain rates?
3. Is it possible that there will be
additional proceeds that will increase the gain?
TAX ELECTIONS AND DECISIONS
The determination of whether the
taxpayer has realized a loss or a gain as the result of experiencing a catastrophic
event is often complex. Cost, as discussed above, is subject to multiple
determinations. The extent of the loss and the applicable insurance recovery is
not always completely known at the time of having to file a tax return. Tax
returns have required due dates, some extension of time to file the returns is
available, but that may not be adequate for the situation. The taxpayer is
placed in a position that the return must be filed with the best information
that is available at the time. In some cases, an amended return may be needed
later to adjust the original filing, while in other cases the adjustment must
be addressed in a subsequent year’s filing.
In any case, taxpayers should not delay
filing returns that are due. A delinquent return carries with it significant
potential for penalties. Even if the original return has a loss and a
delinquent return would not have any penalty consequences, a later amendment,
reporting taxable income, would generate a penalty.
Reporting
a Gain
–
Taxable (pay tax currently)
or
Deferred (not currently
taxed) - no proscribed form
The first critical step is discussed
above, determining if a conversion into cash has occurred. If the insurance
company provides a replacement, then no conversion has taken place; no tax
implications are triggered. This is very unusual. Even when the insurance
company provides the contractor, the insured is usually required to sign a
contract with the vendor. The insurance company issues checks payable to the
insured and the contractor.
“INVOLUNTARY CONVERSION”
CONVERSION INTO
Where
money is involved and the proceeds exceed the cost basis, a gain is generated.
If a decision is made to defer the gain, the transaction is reported as an
involuntary conversion.
Where reinvestment is
chosen, the record keeping must be complied rigorously; annual reporting of the
status of the reinvestment process, including the disclosure of the insurance
proceeds received. These reinvestment reporting rules must be adhered to during
the replacement period. As part of this process, it is recommended that the
taxpayer schedule out repair plans to estimate if all the required expenditures
will be completed in the required time frame or will an extension of the
replacement period be needed due to conditions beyond the taxpayer’s control.
The involuntary conversion is treated
as a “sale transaction” within the tax code The tax code provision allowing an
exclusion of up to $250,000 per taxpayer, ($500,000 for married couples) on the
“sale” of a primary personal residence may apply. Generally, the law (Revenue
Code Section 121) requires:
1. The home must be used
as a primary personal residence for 2 of the last 5 years (there are additional
requirements that can affect this requirement).
2. The taxpayers must
have owned the home for at least 2 years prior to the sale and
3. The taxpayers have
not used the rule for at least 2 years.
Additionally, in an
involuntary conversion, the home must be “completely destroyed.”
An additional requirement must be met
for gain resulting from damage to a personal residence. The code demands that
the residence be “completely destroyed.” However, Congress never defined
“completely destroyed.” There is an obvious situation where a home has been
futned to the ground. But can the home the “completely destroyed” and still
have significant structural features remaining. In a 2001 memo the IRS defines
a broad spectrum of possible conditions other than a complete burn type
situation. Therefore, if your home has had significant damage the possibility
of applying the exclusion should be examined very closely.
After a Section 121 gain exclusion is
applied to the involuntary conversion gain all remaining gain might be
eliminated from current taxation with a deferral election.
For the exclusion to apply, the home
must be completely destroyed in the incident. Complete destruction is measured
in terms of actual physical destruction. The loss may qualify as complete
destruction where the cost to repair is sufficiently high to make it
economically unfeasible to make the repairs, regardless of the amount of the
actual destruction,
The time to complete the repairs and
the complexity of the repairs may also affect the decision to pay the tax or
defer the gain.
What about a partial taxation and a
partial deferral of gain? For example, assume the proceeds are $1,000,000 and
the gain is some portion of that amount. It is believed that the repairs can be
completed for less than the full sum. It is possible to report a portion of the
proceeds as taxable, but not in excess of the gain and defer the balance.
If all or a portion of the gain is
reported as taxable, it is treated as a capital gain item. To make sure that it
is taxed at capital gain rates, it is necessary to determine if there have been
any capital losses deducted in the prior five years that were allowed as
ordinary losses. These losses will necessitate that the gain be taxed at
ordinary rates to the extent of those prior ordinary losses.
Reporting a deferral of the gain
NO PROSCRIBED FORM, INCLUDE IN
DISCLOSURE:
The IRS does not have a proscribed form
to report a deferral of a gain as there is for reporting a loss (Form 4684).
However, the code and regulations do require certain information be included in
the disclosures during the post-event, replacement reporting period.
Event identification – clear
description including any federal or state disaster declarations
Year(s) gain realized – the gain may be
realized in more than one year, each year of realization must be reported
Proceeds received Less Gain
excluded = Gain realized
Gain recognized (taxable / partial or
full deferral)
Identification of property lost - clear
description including address of property for real property, for replacement
properties the location, cost investment
Dates of loss, reinvestment
Election to defer gain under indicating
the appropriate Code section
Identification of replacement
property(ies) or repairs – type of property, location
10 TIME PERIOD TO COMPLETE QUALIFIED REPLACEMENTS
Included
in the law’s relief provision is the setting of time restrictions in order to
take full advantage of the tax deferrals on a gain. The time restrictions have
the most impact on taxpayers who have a gain and wish to defer the payment of
tax by completing a qualified replacement or repair of the destroyed property.
The replacement period begins at the time the catastrophic event occurs. Any
acquisitions of what might be considered replacement property acquired prior to
the catastrophic event, generally, cannot be counted as qualified replacements.
The “replacement period clock” continues to run while the insurance
negotiations are in process. During this time, it is possible that the
insurance company makes payments that are not in excess of the taxpayers cost
basis for the destroyed property. Only after the cumulative insurance proceeds
exceed the cost basis will there be a gain realized. Once gain is realized, a
“second clock” starts to run. The second clock starts at the end of the year in
which any gain is first realized. It continues to run for two years (four years
for federally declared disasters) after the end of that year. The whole period
from the point of the loss to the end of the “two / four year” period is
defined as the replacement period.
Assume
a loss on October 10, 20x0.
· The insurance company
makes some payments in 20x0.
· These payments do not
exceed the cost basis of the property.
· Sometime in 20x1, the
insurance company makes a complete settlement of the claim that cumulatively
brings the proceeds to an amount in excess of the cost basis.
· A gain has been
realized in 20X1 after applying any Section 121 gain exclusion.
The second clock (two
/ four year), starts to run at the end of 20x1 for a two-year period ending on
December 31, 20x3 (two years after the end of the first year in which a gain is
first realized).
EXTENSIONS OF TIME TO
COMPLETE REPLACEMENT
What if the replacement time clock is
running out but the taxpayer is unable to complete the replacement before the
end of the replacement period? Congress expects people would be able to comply
with the time requirement. Circumstances may arise that are beyond the control
of the taxpayer. The law acknowledges the possibility. Congress gave the IRS
the power to extend the period to complete the replacement. In fact, this is
the only area where the IRS has any authority to allow for time extensions in
casualty and involuntary conversion situations.
To qualify for an extension, the
taxpayer must have a credible story. Simply stating, “I have not gotten around
to it” is not a good reason. Some reasons that might be valid would include the
delay in settlement of a lawsuit that would affect the type of reinvestment
that would be completed by the taxpayer. Availability of building supplies due
to the massive rebuilding in the area might also qualify if it can be
documented. The taxpayer must demonstrate a reasonable attempt to meet the
deadline and the extension requested is due to circumstances that are beyond
the control of the taxpayer. The regulations specify the information that needs
to be included and the IRS office where the application needs to be sent. The
application can be as short as a one-page letter. There is no specified form.
11 STATUTE
OF LIMITATIONS
Under normal conditions, a tax return
is subject to IRS scrutiny for a period of three years after it has been filed.
A return for 20x0 filed on April 15, 20x1 will be subject to examination until
April 15, 20x4, three years after April 15, 20x1. In the case of an involuntary
conversion, the period from the event to the year of the final reoccupation of
the residence may span three or more years. This period includes the receipt of
insurance proceeds and the reinvestment of the proceeds up to the end of the
statutory replacement period, including granted extensions. All the returns for
all the years in which any of these activities occur remain “open” for
examination for the period that ends three years after the final notification to
the IRS that the reinvestment has been completed. In the case where the event
occurred in 20x0 and the replacement period and final completion of the
reinvestment are completed in 20x3, followed by filing the 20x3 return on April
15, 20x4, all returns for 20x0 through 20x3 are open for examination through
April 15, 20x7 (three years after April 15. 20x4).
12 QUALIFIED
REPLACEMENT PROPERTY
The law states that in order to defer
paying tax on any realized gain from an involuntary conversion, the taxpayer must
use the proceeds to purchase qualified replacement property (including repairs
to the damaged property). Generally, the replacement property must be “similar
or related in service or use to the converted property.” This requirement is
not the same as “like kind.” “Like kind” is a term that applies to tax-free
exchange transactions. For personal use real estate, the “similar use”
requirement means any improved personal use real estate will qualify. The
concept of like kind is seen as being broader (applying to the characteristics
of the property) while “similar or related in service or use” relates to how
the taxpayer uses the property.
Personal use real estate is not an
undeveloped lot. Although a newly acquired lot subsequently improved within the
replacement period qualifies. A previously acquired lot that is built on after
the catastrophe will not qualify, but the new construction will.
Immediate conversion upon acquisition
of a residence into rental property would not meet the standard. Other than
those restrictions, as long as it is real estate and functions as “for personal
use” the standard is usually met for lost personal use real estate.
It is not necessary to spend the actual
cash received from the insurance recovery. In fact, if the taxpayer wishes to
borrow funds to complete the reinvestment and take the insurance proceeds and
invest them in the stock market, that is acceptable.
MULTIPLE
REPLACEMENTS FOR SINGLE LOSS?
For
real estate it is permitted to acquire more than one replacement property
rather than invest the funds in one single replacement property. The multiple
replacements may be acquired over a period of time and not simultaneously. How
does the taxpayer allocate the deferred gain. Allocate gain, pro-rata over the
total cost of all acquisitions
ORDER
OF REINVESTMENT
As replacement funds are being spent on
qualified properties, the tax law sets the way the gain and cost basis are
affected:
· Replace Original Cost Basis
· Absorb Gain
· Remaining un-invested proceeds are
taxable
· Addional costs increase the cost basis.
13 SALE
OF RESIDUAL LAND / OR HOLD FOR LATER SALE
“FEASIBLE”
TO REPAIR / SALE OF RESIDUAL REAL ESTATE
Another consideration that often arises
is an outright sale of the “residual damaged property” that remains after a
casualty. The issue is the potential for deferral of the gain on the sale of
the combined insurance and sale proceeds including the gain from the land sale
in the computation of the IRC Section 121, $250,000/ $500,000 gain exclusion
and remaining gain to be deferred. The level of repairs that are required to
bring the property back to its pre-event condition must be analyzed. The result
of the analysis may affect the ability of the taxpayer to combine the
subsequent land sale as part of a single transaction. This situation is best
explained by example. The homeowner decides to sell the damaged property
instead of repairing / rebuilding. At one extreme, the complete destruction of
the home in the loss event would qualify for single transaction treatment. As
severity of the loss decreases there is no “bright” line where it is easy to
see the point at which the loss is not significant enough to justify the
subsequent sale of the residual property as part of the initial casualty. The
courts’ and IRS rules on the subject of “feasibility” provide assistance. The
question is the cost of repairs compared to the resulting fair market value of
the property after the repair. The rules do not require that the taxpayer
invest in a repair that will cost so much that the repair will be more costly
than the resulting value of the property (a value determined prior to the loss
event). A flood caused by a water heater exploding inside the home would
usually not qualify as damage that qualifies as a major loss and, the insurance
proceeds combined with a subsequent sale of the home would not qualify for any
deferral of gain.
The following example demonstrates the
difference in outcomes where a transaction is split and where it is combined as
one “involuntary conversion” transaction:
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Basic
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With
Lot Sale
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Only
Lot Sale
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Insurance
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600,000
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600,000
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Lot Sale
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300,000
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300,000
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Total
Proceeds
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600,000
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900,000
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300,000
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Cost
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300,000
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300,000
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-0-
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Sec. 121 Exclusion
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300,000
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500,000
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200,000
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Gain subject to deferral
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-0-
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100,000
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Taxable
Gain
100,000
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Required Reinvestment
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-0-
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400,000
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na
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If the sale of land qualifies as part
of the original transaction for tax purposes, (the sale is the result of
actions that originated with the casualty event), the gain will be subject to
the exclusion benefits and any remaining gain can be deferred.
The
IRS has a number of useful booklets for taxpayers who experience a
catastrophic physical event. The IRS has combined a number of these separate
publications in two publications,
2194 for
individuals and 2194b for
businesses.
The
booklets can be accessed on the IRS website at www.irs.gov.
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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.
JOHN
TRAPANI
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Certified
Public Accountant
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2975
E. Hillcrest Drive #403
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Thousand
Oaks, CA 91362
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(805)
497-4411 E-mail John@TrapaniCPA.com
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Website: www.TrapaniCPA.com
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Blog:
www.AccountantForDisasteRrecovery.com
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It All Adds Up For You
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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
© 2011, 2013 & 2013, John Trapani, CPA,
