P of R # 1

For Individuals and Businesses and Investors in Tangible Property:

For Individuals and Businesses and Investors in Tangible Property:
This material is divided into sections that cover specific areas of the tax consequences related to the recovery process from a catastrophic physical property loss. The following is an overview of the concepts that are covered:

The material primarily addresses the losses of individuals for personal, business and investment losses. Where differences arise for businesses not operated in a sole proprietorship, such as partnerships, corporations and LLCs the differences will be separately stated.

Circumstances (Disaster or other Catastrophe)
Type of loss: complete loss or partial loss
Assets lost
Loss or Gain
Computing the loss or gain
Qualified Replacement property
Tracking the recovery / Reporting
Compliance issues
“Change of mind”
Complications, Interpretations, Clarifications
Interest and Property taxes

For every job, tools are required. Recovering after a catastrophic event is no different. Whether recovery is assisted by insurance proceeds, income tax benefits or a combination, documentation is required to substantiate both insurance and tax aspects. Anything you do to improve the quality of the documentation will increase your recovery success.

Always keep a diary of all conversations, document the physical aspects of the recovery by photographing everything you can. Photographic documentation is always evaluated in hindsight. We look back and say, “if only I had recorded the status of that damage three months ago.” To avoid this lament, record as often and, in as much detail as you can. Later, you can decide what is no longer useful rather than being sorrowful about what was not recorded. 

People who have experienced a major physical catastrophe can be expected to be “angry, confused and vulnerable.” There are normal responses to being subjected to “tremendous stress.” In the usual case homes have been destroyed, these homes have been the prime physical source of family stability and safety. These people are likely in “psychological shock.” In a natural response, taxpayers doing their best will find new creative ways to deal with the complexity of the situation. 

For an official list of federally declared disasters go to Www.FEMA.gov/disasters.

It is imperative to understand that the tax laws related to casualties and disasters are unusual. For one, we have to understand that the basic law involves a claim of taxation of all receipts and non-deductibility of personal losses. Therefore, the two code sections 165 and 1033 and others are unique in that they reduce or eliminate taxation of insurance proceeds and allow deduction for personal losses. It turns out that sometimes even the tax laws can display empathy for the people who have been affected by such things as casualties and disasters.

The tax law differentiates between realization of income or a loss and recognition of the item as a tax return reportable event. Realization refers to the receipt of cash or having experienced a loss (the event). Recognition involves reporting the event on a tax return. Some events are reportable and others are not. Some have several circumstances that must be understood to determine if the realized event has any effects that must be reported to the Internal Revenue Service and state tax authority on a tax return. The material in this document discusses the major aspects of realization and recognition for the bulk of aspects related to a casualty or disaster event.

In addition to insurance proceeds, additional funds may become available to taxpayers as a result of a catastrophic event. For individuals, many of these payments are free of any tax consequences. They can come from FEMA, the state, local governments, non-profit organizations and even employers. Generally, payments given without any “strings” or to reimburse medical, housing, or burial expenses are not subject to tax. Payments requiring the payments be used to repair the home or reimbursement for damages to the home must be treated as additional insurance proceeds. But if they are paid to the taxpayer without any restrictions other than they are assistance in regards to the taxpayer having experienced a specific catastrophic physical event, then they are “tax free.”

Securing a Small Business Administration (SBA) loan as part the recovery does not create taxable income. It is a contract that includes an obligation to re-pay money borrowed plus interest. In some cases, the SBA will forgive a portion of the loan once it is reduced to a specified balance. The forgiveness does have income tax consequences. A forgiveness of indebtedness is treated in the same manner as additional insurance proceeds. The treatment of the forgiveness depends on several factors including:
·         The time period in which the forgiveness occurs,
·         The replacements made by the taxpayer,
The forgiveness may be taxable or simply reduce the Adjusted Cost Basis of the replacement property.

The SBA may make disaster declarations without a “Federal Disaster Declaration” being made. The SBA declarations only make their disaster relief loans available to taxpayers; it does not make the event a Federal Disaster that allows taxpayers to take advantage of special disaster tax benefits. Federal disaster declarations are listed at FENA.gov / disasters.

Cost basis is only an important component in the recovery process for income tax considerations. For insurance, it is only important that the insured prove the cost to replace the damage, that is not the same cost basis that we are concerned with for tax purposes. Cost can be simple. For a home that was not modified after acquisition, the purchase price plus some of the closing costs would be its cost basis. That rarely is the case. Maintenance expenditures are not part of the cost basis. The cost of mowing the lawn is not an improvement, the cost of planting a tree or a rose bush is an improvement.

Items acquired by gift or inherited have special rules. The “cost” of an item received as a gift is determined differently from items that are received through inheritance.

In prior years, before the recent housing value downturn, we would not be too concerned with the next step as the assumption had been that real estate values are increasing. In fact, for determining a gain, that is where the computation of cost basis does stop. For purposes of determining a loss, an additional consideration comes into the computation: The fair market value of the property immediately before the catastrophic event. If that fair market value is above the actual cost basis, there is no adjustment to the cost basis. If the fair market value is less than the actual cost, the cost is “adjusted” to the fair market value to arrive at the “adjusted cost basis.” The decrease in fair market value that results from the difference between the fair market value and the actual cost is considered a personal, non-deductible loss. When the IRS examines a return, they look for personal losses inappropriately deducted in the return.

The following example demonstrates how fair market value below the actual cost affects the computation of a loss.

Value before event

Value after event

Loss in value resulting from loss

Insurance Proceeds

Adjusted Loss before deduction limitations

The cost of real estate involves categories such as land, building, landscaping, asphalt driveways, patios, etc. For personal use real estate, the cost of each category is not relevant. If the building burns, the loss is not limited to the cost of the building. For personal real estate, the IRS looks at the cost of the complete property as one “integral unit.” Even though the land does not burn, the loss is computed on the reduction in the value of the whole property. The loss is compared to the adjusted cost of the whole property, including land. Cost is the attributable to the property is the maximum limit of the loss.

The decrease in value before the casualty of $300,000 ($2,000,000 purchase less $1,700,000 value before the event), is not part of the deductible loss, but it still remains part of the cost basis for the asset going forward.

The example below does not include insurance proceeds. The decrease in value is $500,000 (value before the event, $900,000 less the value immediately after, $400,000). The loss is limited to the cost basis ($400,000), which is less than the loss in fair market value ($500,000).

Value before event

Value after event

Loss in value resulting from loss

Insurance Proceeds

Adjusted Loss before deduction limitations

The above example also demonstrates a concept in the tax code, “integral nature.” The “integral nature” concept make a distinction between personal use real estate and other real estate. For personal use real estate, there is no need to allocate between land and improvements when determining the loss from a casualty. In other words, based on the above example, although the construction costs were $300,000, the allowed loss was based on the total cost of $400,000. Therefore, while cost is a limit, of the economic loss of $500,000, the taxpayer is allowed to deduct the full cost of $400,000.

The following example demonstrates a gain: The total cost, including the land is $400,000. That is compared to the insurance proceeds of $1,000,000. An exclusion that is discussed later, $500,000 reduces the gain of $600,000 to a $100,000 gain realized. The realized gain may be deferred or reported as a capital gain.

Cost of construction

Total Cost

Insurance proceeds

Gain before exclusion

Sec 121 Exclusion


Gain to Defer

The last example combines two elements of the above examples. 


Cost of construction

Total Cost

Value before

Value after

Decrease in value

Insurance Recovery

Adjusted Loss before limitations – limited to Basis less Insurance proceeds



There are cases where the allocation of cost between land and improvements will be required because both business and personal use are involved.

Gifts have a cost basis that is called “carryover basis.” It is generally the cost basis in the hands of the person making the gift, but it cannot exceed its fair market value at the time of the gift.

Inherited items have a cost basis that is equal to the fair market value, generally, at the date of death of the person who made the bequest.

Assume that Aunt Jenny gives an antique that she purchased 60 years ago for $10.00 that has a value at the time of making the gift of $100.00. The person who receives the gift has a cost basis in the antique of $10.00. On the other hand if Aunt Jenny gifts her car that she paid $15,000 20 years ago that now has a value of $1,000, the person receiving the car has a cost basis of $1,000 for that car. If these items had been received as bequests after the death of Aunt Jenny, these items would have a cost basis to the person receiving them of $100.00 for the antique and $1,000 for the car.

The IRS does not specify how records should be kept. They do require that the records be kept in a manner that allows the taxpayer to demonstrate to them that the reporting on a tax return results in the “correct tax.” Generally, taxpayers do not have to submit documentation with the return when it is filed. The substantiation must be maintained by the taxpayer.

The need for adequate documentation cannot be over-stressed. However, courts have been reasonable where the critical documentation has been destroyed in the casualty event. This does not mean that taxpayers should be loose with their documentation record keeping. In fact, while the courts may show leniency a taxpayer with full documentation will do better than a taxpayer relying on the kindness of a judge.

In addition to the formal records of the home’s purchase and major improvements, other materials are often useful to demonstrate cost. It is unlikely that a taxpayer has all the receipts for all the linens in a closet. A photograph of the closet might add some level of proof in addition to the photograph being a memory aid to list all the items stored in the closet. The loss on personal property is limited to the lower of the value of the items just before the event or their cost. The receipt for a custom-made couch is wonderful, but a recent photo will show its condition demonstrating a level of “depreciation” in value due to use.

A list of major items that are important evidence in the documentation process include the following:
Basic acquisition cost, improvements
Adjustments – decrease in value before event
Inherited property
Valuations (before / after)
Appraisal (& Appraiser)
Cost of Repairs methods
Physical location of items lost
Insurance proceeds
Replacements (Repairs and /or Acquisitions)

The payment of insurance proceeds should be documented very carefully, including a photocopy of the check. Retain any materials that the insurance company sends with the payment or as support for the payment. Often, the insurance company will have codes on the check or stub. If the material accompanying the check does not include an explanation of the codes, ask the company for the key to the codes. Verify the codes related to the payment are consistent with your understanding of what was being compensated for in the claim. Note on claim documents when the when the claim was filed, how much was claimed compared to the amount paid, and reasons for differences.

The insurance policy can provide payments for the following:
Real property – Structure (usually Coverage “A”)

Real property – “Other Structures” (usually Coverage “B”) generally 10% of Coverage “A.” Additional coverage can often be acquired.

Personal property (Contents) (usually Coverage “C”), generally 50% to 75% of Coverage “A.” Additional coverage can often be acquired.

Additional Living Expenses (usually Coverage “D”), usually based on the quality or living standard as determined by Coverage “A.”

Other coverage for “Scheduled Property” items, (specifically listed in the policy).

Medical expenses

Flood insurance is only available through a federal program.

Earthquake coverage is most often a separate policy. Coverage quality can vary over a wide range.

Some insurance proceeds may be income, or be tax-free. They may be subject to partial tax-exclusion and the balance subject to possible tax-deferral.

All evidence related to spending funds to return to a pre-event status, including acquisition of replacement property and the cost of repairs and experts must be retained as evidence of the reinvestment. Using a computer worksheet to summarize the accounting for the funds in addition to maintaining the actual source paperwork is essential. The specific tax treatment of each type of insurance payment is covered in this material.

Vehicles, boats, trailers, etc., all have separate insurance coverage availability and thus are treated separately when reporting a loss for tax purposes.

Business losses are treated separately from personal losses, even when the business is operated from the personal residence.

Reporting a gain or a loss will be based on the taxpayer’s receipt of funds in each of the specific categories compared to cost basis or adjusted cost basis of the assets lost or damaged. 

  “Tax Elections,” Decisions and Tax Consequences
                                              8                     A LOSS
                                              9                     A GAIN

Cost Basis Determine Preliminary FMV
Insurance proceeds
Analysis is completed by category

Allocation between damaged and undamaged property
(Total cost for personal use real estate is available to absorb tax loss)
Area? / Relative value? / Something else?

“Tax elections,” Decisions and Tax Consequences
When an event occurs, the first thing that you need to do for tax purposes is determine if there is a gain or a loss. Your initial analysis may later change, but the initial analysis will assist you the early days of the recovery. However, it is important to keep the possibility of an alternative conclusion in mind.

It is also important to refrain from rushing into a loss claim on a tax return. While the initial benefit may be very enticing, a later recovery that requires a reversal of the original loss can be very costly. The initial benefit may get you $15,000 in tax savings, but the later recovery could easily cost you $25,000 or more.

It is possible to have a gain in one category while having a loss in another category.

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, 2012 & 2013 John Trapani, CPA,