P of R # 4

17        PART PERSONAL USE / PART BUSINESS – IRS Rev. Proc. 2005-14

The emphasis in this material is on personal use real estate (generally the primary residence) and its contents (personal homes, not rentals or property used in a business).

Application of the tax benefit rules also apply to people who pay rent for their home. Renters can use the tax relief provisions that apply to personal property lost, as well as additional living expense insurance benefits that a renter’s policy provides.

Income tax deductions are not a substitute for filing an insurance claim. If no insurance claim is submitted for a loss covered by insurance, a tax deduction cannot be claimed for the loss as a substitute. In most cases, insurance is not required to be purchased as a prerequisite to reporting a loss on a tax return. A loss may still exist after considering the insurance coverage that may be allowed as an income tax deduction.

The “reporting” of damages to an insurance company is not the same as the income tax reporting. The insurance company does not have any right to see how the insured reports the outcome on a tax return. They only have a right to see documentation that directly affects the claim of loss. The IRS has the right to see all relevant documentation which may include some or all of the insurance documentation.

Insurance recovery is generally based on the value of the property lost, often the cost of replacing an item is the measure of the reimbursement. The insured must establish within some basic parameters ownership of the property lost. The fact that the item was purchased for $20.00, twenty years ago is of little relevance. For income taxes the cost is relevant and its value prior to the loss is also relevant. Replacement cost might be useful, but is not directly relevant.

Unfortunately, there are decisions or events subsequent to the initial loss event that can make the situation more difficult for taxpayers. Some of these additional events are well within the taxpayer’s control and some are not within the taxpayer’s control.

 What if no reporting is made of the proceeds or the reinvestment to the IRS? The law states, where no reporting is submitted to the IRS the law assumes that where a gain has been realized a qualified replacement has been elected and will be completed within the required period. The statute of limitations requires reporting to the IRS in order that the statute can expire with the normal passage of time. That requirement is not met if there is no reporting. The IRS continues to have the ability to examine the applicable returns “forever.”

If the reinvestment is not made, then a tax liability along with penalties and interest hang over the head of the taxpayer.

A 2001 IRS position poses a problem for taxpayers who fail to report a gain from an involuntary conversion. If the taxpayer does make the reinvestment, but does not report the results to the IRS, any acquisitions or repairs can be excluded by the IRS as qualified replacements upon audit.

The 2001 IRS position makes a distinction between the deferral transaction and the reinvestment transaction. The IRS acknowledges that the deferral is automatic if no report is made. However, in the 2001 IRS position the IRS is very clear that a reinvestment does not meet the qualified reinvestment rules unless it is reported to the IRS in a return for the year that the reinvestment is actually made. A taxpayer who is not aware of the rules and has made an unreported deferral decision is put in a potential penalty position because the reinvestment has not been made according the IRS since it has not been reported. And since it has not been reported, the statute of limitations remains open indefinitely.

In some cases the taxpayer may purchase a temporary home after the event while the primary home is being repaired or it appears that the settlement process is going to be very protracted. What to do? A solution may be purchasing a temporary home that will be sold after the home is reconstructed. But if time passes without resolution, the temporary home may end up being the replacement home. How do you deal with all this when you are required to file a tax return on an annual basis? Annually, you have to commit, is the home purchased a temporary home or a permanent replacement? Keeping in mind that reporting is the prime responsibility it may or may not matter if you treat the temporary home as a part of your replacement plan. Let’s look at several scenarios.

Purchasing Temporary Home, turns out not to be part of permanent replacement plan:
If the home is not declared as part of the permanent replacement plan, then no portion of the deferred gain is allocated to the purchase reducing the cost basis. Since the home is intended to be held for only a small period of time, it is unlikely that its value will not change significantly, but the taxpayer gets to deduct the mortgage interest and property taxes. The sale may have a small or no tax impact. If the home value does go up and the home is held for at least 2 years, then the gain may be eliminated by the IRC Section 121 exclusion.

Purchasing Temporary Home, turns out to be part of permanent replacement plan:
If the temporary home is not declared as part of the replacement, and it turns out to be the permanent replacement due to a change in circumstances, the deferred gain has no asset to be attached to and it will become taxable.

Purchasing Temporary Home, treating it as part of permanent replacement plan:
If the temporary home is declared as part of the replacement plan, deferred gain will be subtracted from the cost basis. Keeping in mind that the gain may have been reduced by the IRC Section 121 exclusion, up to $500,000 may already be excluded. If the home is sold before it has been owned for at least 2 years and occupied for at least 2 years, then all deferred gain will be taxed. If it does meet the 2 year requirements, then the exclusion can reduce or eliminate the tax impact. If the taxpayer does acquire an actual permanent replacement home or repairs the damaged home (within the required replace period restrictions), then the deferred gain can be allocated to both the temporary and permanent homes on a proportional basis related to the value of each, not necessarily the time of acquisition.

The process of recovery must include a clear planning process of how to proceed. Selection of how the taxpayer protects the family and at the same time make reasonable decisions that incorporate all the situations that can arise should be thought trough.

The tax law includes a concept: “Allowed or allowable.” How this affects people who decide not to report a loss is that a loss is allowed to be deducted for losses that actually occur. If the loss is not claimed, the IRS can claim that it should have been claimed and that non-recognized loss is assumed to have been claimed without the taxpayer actually gaining the tax benefit. In other words, the cost basis of the property is reduced by the IRS when it is later sold to reflect the loss that was not claimed.

Death and divorce create special problems when they occur after the catastrophic event and prior to the completion of all the recovery process. The prime issue is that any gain realized by a taxpayer “follows” that taxpayer. The deferred gain cannot be transferred to another taxpayer to complete a replacement. It must be dealt with by the taxpayer who realized the gain.

If the taxpayer dies after the event, that person is not available to complete the reinvestment and the taxes must be paid on any gain that the taxpayer realized prior to dying that was not reinvested. In one case, a jointly owned property was destroyed. A lawsuit was filled and settled many years later generating a gain. The husband’s health started to fail .The family’s concentration was placed on the health issue. The reinvestment was put on the back burner. The husband passed away two weeks before the wife closed the purchase of a replacement residence. The portion of the gain attributable to the husband was required to be reported on an amended joint return for the prior year in which the lawsuit was settled.

Divorce can create significant tax consequences if the divorce occurs during the replacement period or the consequences are not thought out prior to the divorce settlement becoming final. In a simple case where the gain is attributable to a residence, the solution may be that each party takes half of the proceeds and make separate qualifying reinvestments. What if the assets lost are business assets of one of the spouses? Assume that a business operating a machine shop burns, destroying all the equipment. The business had been operated by the husband. The wife had no interest or involvement in the business. The business had been operated as a sole proprietorship and operations were reported on the joint tax return of the husband and wife. The business was located and the taxpayers lived in a community property state such as California. For tax purposes, each taxpayer owned half of the business and realized half of the gain. A divorce ensues during the replacement period. The wife is held to have realized half of the gain and is responsible for paying the tax on that portion or making the reinvestment. The wife will have to stay involved until the replacement is completed and all the community property can then be allocated between the divorcing parties.

What if the taxpayer simply has a change of mind regarding a prior reporting decision? Some decisions are reversible and some are not.
       Not going to reinvest after making election to reinvest proceeds:
   “I deferred gain. I want to pay tax and not rebuild, not reinvest.”
     Taxpayer must wait until the end of the reinvestment period, file an amended return for the year the election was made and pay tax. IRS will bill for interest, but not underpayment penalties.
Once an election has been made to replace the property lost and defer the gain, only the expiration of the replacement period without fulfilling the commitment to complete the replacement can reverse that decision. Unfortunately, that requires the filing of an amended tax return years later with the payment of the tax and interest.

·         “I want to reinvest. I originally reported a gain and paid the tax.”
     Amend original returns to “un-recognize” gain reported that is reinvested
The taxpayer may have reported a gain in the year the original receipt of proceeds and later decides that deferral is a better decision. The law allows the taxpayer to change the decision in this case. The taxpayer goes back and files an amended return, pays the tax and interest and completes the required reinvestment. The reinvestment still must be completed within the required reinvestment period based on the date the proceeds created a gain situation. However, see the discussion of the IRS requirements for reporting re-investments timely at the end of this section.

      “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.
There are situations where the taxpayer has received funds that are not adequate to cover the loss, a loss is claimed on a tax return. Later additional proceeds are received. The additional proceeds have to be evaluated on a cumulative basis. Reversal of the prior loss deduction must be reported as income in the year the additional proceeds are received to the extent of the lower of the deduction benefit of the prior loss deduction or the additional proceeds received. The “income” generated from the reversal of the loss is reported as ordinary income in the year the additional proceeds are received, not capital gains. If the prior loss is totally eliminated resulting in a gain, that gain may be deferred. The two-year replacement period clock begins to run at the end of the year the gain is realized. Again, see the discussion of the IRS requirements for reporting re-investments timely at the end of this section.

·   Original tax return filings incorrectly filed
·   Corrections of previously filed returns can generally be amended as proscribed for all returns

In a 2001 memo, the IRS specifies that once a tax return has been filed, if reinvestments are not reported on that return that took place during that year, they are “forever” assumed that they were not intended to be declared as “qualified replacement properties.” Therefore, it is recommended that even for loss situation, it is sometimes possible that because subsequent proceeds may change the situation, that these properties be reported on each return in the form of a statement that the property is being acquired as a replacement for the damaged property.

17    PART PERSONAL USE / PART BUSINESS – IRS Rev. Proc. 2005-14


Mixed use refers to property that includes both business and personal use portions. The business use might be part of the main residence structure or located in a separate building located on the property. The Section 121 gain exclusion discussed above comes into play for mixed-use real estate. The exclusion rules are both restrictively and liberally applied. On the restrictive side, the IRS has limitations on what is considered applicable personal residence and transaction limitations.

Where an involuntary conversion of a primary personal residence involves part of the home being used for business purposes such as renting out a room or using a room for business, the application of the exclusion is very favorable. The gain on the business portion qualifies for exclusion. If the business use property is a separate structure from the main residence, an allocation of cost must be made. The gain on the business portion does not qualify for the exclusion, but may qualify for deferral if repaired or replaced with other business property.

If at the time of the catastrophe:
The taxpayer has met all the Section 121 requirements, except that it was owned and occupied less than two years as a personal residence, relief is provided. The taxpayer may prorate the exclusion for the period that the qualification has been met. If, for example, 18 months of the two years’ requirements have been met then, 75% (18 divided by 24) of the exclusion may be used. In such a case, if the gain is less than $375,000 (75% of $500,000), the taxpayers will be able to exclude all of the gain.

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.


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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, 2012 & 2013, John Trapani, CPA,