P of R # 3

9          A GAIN

9      A GAIN
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.

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.”

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.

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?


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.


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
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

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).

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.

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).

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.

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

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.

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:

Lot Sale
Lot Sale

Lot Sale

  Total Proceeds
Sec. 121 Exclusion
Gain subject to deferral
Taxable Gain
Required Reinvestment

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.

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

2975 E. Hillcrest Drive #403

Thousand Oaks, CA 91362

(805) 497-4411       E-mail John@TrapaniCPA.com

Blog: www.AccountantForDisasteRrecovery.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.  
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,