PROCESS
OF RECOVERING FROM A CATASTROPIC LOSS
INCOME
AND PROPERTY TAXES CONSEQUENSES AND REQUIREMENTS
PART
5
18 AFFECT
OF CHANGING USE AFTER REPLACEMENT
19 ALE
– ADDITIONAL LIVING EXPENSE REIMBURSEMENTS
20 “EXPERTS”
–TAX REPORTING
18 AFFECT
OF CHANGING USE AFTER REPLACEMENT
Conversion of Personal Use Real Estate
to Rental Property After Rehabilitation
BEFORE: Property used for
personal use
AFTER: Change in use to
rental after rebuilding
Qualified replacement has not taken
place in this case.
Property was not kept for personal use.
If the home is rented after the repair,
the destroyed personal use real estate replacement has not been completed as
the use of the property has changed.
Home not re-occupied. But not converted
to other business or rental use
In some cases, the taxpayer may repair
the damaged home, but decides not to re-inhabit it upon completion of the
repairs. The question arises: “Has a qualified replacement taken place?”
As long as the residence remains a
personal use home and not a business or rental home, the requirements have been
met. The sale of the home “immediately after completion of the repairs” raises
the question of whether the repairs were made to a personal use residence or a
property held for investment. There is no definitive regulation or ruling on
the subject. The taxpayer should be able to make rational decisions about the
economic decisions related to the best way to recover from a catastrophe. If
the value of the home will be greater after the repairs are complete than the
cost of the repairs, there is an economic reason to complete the repairs.
Additionally, the insurance company may not “allow” the use of the proceeds to
be applied to acquire a replacement home without the insured being paid a
reduced amount. This may be a factor forcing the taxpayer to complete the
repairs to realize the best economic result. A clear intention to convert the
property into an investment would be a problem. The replacement of the personal
residence did not take place in that case. Timing and access to other financial
resources may affect the ability of the taxpayer to follow such a plan.
Another way of dealing with this
situation where the taxpayer desires to dispose of the property upon completion
would be not to designate the home as the qualified replacement property;
complete the repairs, sell the property and acquire the replacement property
all within the required replacement period.
19 ALE
– ADDITIONAL LIVING EXPENSE REIMBURSEMENTS
Additional living expenses are the
costs incurred in excess of the “normal expenses” of food, habitat and commuting
expended prior to the event. These additional expenses are not part of the
catastrophic loss. There is no allowance in the tax law to deduct these costs.
Most residential property casualty insurance policies include a provision to
reimburse policyholders these additional expenses. The tax law does not tax
these proceeds as long as they are used to pay qualified additional living
expenses. If the money is not all spent on additional living costs, the unspent
funds are taxable as ordinary income in the year that the taxpayer no longer
incurs any additional living expenses.
The question is regularly asked:
“The insurance company is willing to
pay me $3,000 a month rent reimbursement for 12 months.
“What if I take a
lump sum of $36,000 and use that to invest in a mobile home or use the money to
make a down payment on a temporary home?”
The answer is not good news. The use of
the funds to acquire an asset such as a mobile home or to purchase a home are
not “expenses,” they are “investments.” While it may be a good economic
decision, the money used in this manner is taxable.
Another inquiry arises:
· The taxpayer already owns a rental
home.
· The insurance company’s additional
living expense proceeds are used to “reimburse” the taxpayers for “rent” on
their own rental home, used as temporary housing.
The taxpayer must
report these ALE insurance proceeds as rental income on the rental property
that is being occupied as temporary housing.
20 “EXPERTS”
–TAX REPORTING
Homeowners usually hire many experts to
assist in the recovery process. Clearly, payments to an architect and a
contractor to rebuild the destroyed home are qualified replacement costs. The
payment of “soft costs” is part of the replacement. There are other costs.
There are four categories that these costs can fall into as detailed below:
1. Proving and documenting the Insurance Claim
of Loss
2. Rebuild
/ Repair / Replace expenditures
3. Tax
Reporting Compliance
4. Other
Settlement Action expenses
The major areas of expenses that are
likely to be incurred in connection with the settlement and recovery process
include the following.
1.
Preparing a Scope of Loss
2. Public Adjusters to assist the homeowner in
negotiation of insurance claim
3.
Attorney fees as an intermediary or part of a legal action
4.
Appraisers
5.
Engineers / Geologist
6.
Architect
7.
General Contractor
8.
Accountant
Some of the experts may only be
involved in one category in the list below. Some experts may be involved in
multiple categories.
The general classifications of proceeds
that can arise out of the settlement / recovery process include the following:
1.
Payment for property damage (home,
personal property, vehicles and boats).
2.
Payment for additional living expenses
3.
Payment for medical expenses
4.
Payment for burial costs
5.
Payment for other personal injuries Involving
physical injury or not involving physical injury, including bad faith
6.
Other costs and expenses
Payments to any consultant / expert to
document the amount of the loss, proving the loss (item 1 above) would be an
offset to any applicable proceeds received. This is true whether it is a
payment to an engineer or a public adjuster in the normal course of the
settlement process including payments to an attorney as a result of settling a
legal action related to the property settlement.
Payments to an engineer or a general
contractor in connection with the actual repair or reconstruction of the
damaged property are part of the reinvestment in the property. An engineer’s
report that was originally prepared for settlement of the claim, but is later
used by the architect to design the replacement / repair, would be part of the
replacement costs.
Assume the following facts:
A lawyer is hired on a contingency
basis; no fees are due unless the action is successful and then 30% of the
gross proceeds are paid to the attorney out of the proceeds received. The
action is successful and the proceeds are paid as follows:
|
Gross
|
Legal
fees 30%
|
Costs
|
See Tax
Accounting
|
|||||||||||||||||
|
Structure
|
$
|
600,000
|
$
|
180,000
|
$
|
60,000
|
1
|
$
|
360,000
|
|||||||||||
|
Contents (Personal Property)
|
160,000
|
48,000
|
2
|
112,000
|
||||||||||||||||
|
Additional living expenses – actual costs
|
100,000
|
30,000
|
3
|
70,000
|
||||||||||||||||
|
Medical expenses – actual costs
|
40,000
|
12,000
|
4
|
28,000
|
||||||||||||||||
|
Personal injury caused by
|
||||||||||||||||||||
|
Insurance company or its agents
|
600,000
|
180,000
|
5
|
420,000
|
||||||||||||||||
|
Punitive damages awarded by Jury
|
600,000
|
6
|
600,000
|
|||||||||||||||||
|
180,000
|
7
|
-180,000
|
||||||||||||||||||
|
Total gross proceeds
|
2,100,000
|
$
|
630,000
|
$
|
60,000
|
$
|
1,410,000
|
|||||||||||||
|
Legal fees 30%
|
630,000
|
|||||||||||||||||||
|
Costs of prosecuting
|
||||||||||||||||||||
|
Costs of prosecuting Action all attributable to determining
structural loss
|
60,000
|
|||||||||||||||||||
|
Net proceeds to insured
|
$
|
1,410,000
|
||||||||||||||||||
The tax accounting would be as follows:
|
Tax Accounting
|
||||
|
Structure – amount subject to possible reinvesting in qualified
replacement property, subject to reinvestment rules with deferral of tax on
realized gain ($600,000 proceeds reduced by $240,000 legal costs)
|
1
|
$
|
360,000
|
|
|
Personal property – amount subject to possible reinvestment
rules to defer any tax on realized gain ($160,000 proceeds reduced by $48,000
legal costs)
|
2
|
112,000
|
||
|
Additional living expenses – actual costs ($100,000 less $30,000
fee) The actual expenses were $100,000 less the net reimbursement of $70,000
results in a non-net non-deductible expense of $30,000
|
3
|
-0-
|
||
|
Medical expenses – actual costs ($40,000 less $12,000) offset of
actual net medical costs of $12,000 results in medical expenses deduction that
may be reported on Sch. A of Form 1040
|
4
|
12,000
|
||
|
Personal injury caused by
|
||||
|
Insurance company or its agents – no actual physical injury (an
allegation of bad faith on the part of the insurance company in processing
the claim) – All Taxable
|
5
|
600,000
|
||
|
Legal expenses related to bad faith claim, deductible on Sch. A,
Form 1040 as a Miscellaneous Itemized Deduction subject to a 2% of Adjusted
Gross Income reduction
|
5
|
-180,000
|
||
|
Punitive damages awarded by Jury – Same as bad faith: – All
Taxable
|
6
|
600,000
|
||
|
Legal expenses related to punitive damage award, deductible on
Sch. A, Form 1040 as a Miscellaneous Itemized Deduction subject to a 2% of
Adjusted Gross Income reduction
|
7
|
-180,000
|
||
|
As to the last two items, since the $600,000 will be part of
Adjusted Gross Income, a minimum of $12,000 (2% of $600,000) will reduce the Miscellaneous
Itemized Deduction
|
||||
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 January 2014.
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
|
||
Certified
Public Accountant
|
||
2975
E. Hillcrest Drive #403
|
||
Thousand
Oaks, CA 91362
|
||
(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, 2012 & 2014, John Trapani, CPA,
