P of R # 6


In some situations, people who experience a catastrophic loss find it is necessary to bring a legal action against the insurance company or a contractor to force proper performance. The process will culminate in a settlement or a court decision. The homeowner will be successful or unsuccessful in the action. The law states that where the suing party is successful, the costs, including attorney fees are treated as a cost of collection. The tax treatment is discussed in the previous section. However, come special circumstances may arise as described below.

Lack of success on the part of the plaintiff bars any deduction of incurred legal costs.

Assume a homeowner sues the insurance company for additional money for the actual loss. The suit also includes a claim for acting in “bad faith” during the claim settlement process. The way the suit is structured can affect the manner in which it is treated for tax reporting later. The homeowner’s claims in the suit might be as follows:


Contract issues – additional payment for actual damages to real and personal property

$   250,000
Bad faith

The suit settles for $350,000. The insurance company refuses to allocate the total proceeds between contract and bad faith issues. Generally, the IRS position has been that the contract issues in this situation were 20% of the total damage claim of $1,250,000, therefore only $70,000 (20% of the settlement) is for contract issues with the remaining $280,000 allocated to settlement of the bad faith claim. This result is a major problem for the homeowner. The $70,000 less any attorney fees (approximately $49,000) can be used to make replacements to the home and defer or eliminate any tax consequences. The $280,000 (much of it needed to complete repairs) is all taxable, related legal costs being allowed only as a “Miscellaneous Itemized Deduction.” The net proceeds after taxes on the $280,000, less deduction for attorney fees of at least 30% might be as little as $112,000, a total of approximately $140,000. This is a terrible result that could have been avoided, if the original claim was structured follows:

Contract issues – additional payment for actual damages to real and personal property
Amount to be determined at trial

Bad faith

Amount to be determined at trial

The $280,000 would be reduced by 30% for legal fees, netting $196,000. The full $280,000 is taxable, the $84,000 legal costs are treated as Miscellaneous Itemized Deductions subject to a 2% of Adjusted Gross Income (AGI) reduction.

Bad faith proceeds are taxable at ordinary tax rates. These proceeds are not subject to deferral or lower capital gains tax rates. The attorney fees related to the bad faith settlement and judgments are not offset against the proceeds, they are reported as “Miscellaneous Itemized Deductions” the tax benefits of which are often lost due to several adjustments and limitations that will come into the computation.

Assuming total AGI is $320,000 including other income $60,000 and deductions including the Miscellaneous Itemized Deductions reduced by $6,400 (2% of $320,000) total $90,000. Taxable income could be $226,000 ($320,000 less $90,000 and one exemption). But due to the amount of the Miscellaneous Itemized Deductions, it is likely that the Alternative Minimum Tax would come into the mix. Federal and state income tax applicable to the only the $280,000 portion of the AGI, could total $78,000. Thus the $350,000 less 30% legal fees and taxes of $78,000, leave the taxpayer only $167,000 to repair the damaged property.

With the above allegation format, there is no roadmap left for the IRS. The taxpayer can take a reasonable allocation. This results in about $81,000 more that is available to the homeowner to rebuild. Additional facts may come out at trial that might affect the allocation.

Bad faith and psychological trauma caused by the defendant are treated the same for tax purposes.

The home damaged in the catastrophic event is not being occupied while it is being repaired or rebuilt. The interest on the mortgages is still deductible to the extent it was deductible prior to the event. As long as the taxpayer demonstrates the property is intended to continue to be a qualified personal residence or is being held for sale.

Where the taxpayer acquires temporary housing with a mortgage, the interest on that mortgage may also be allowed. The total interest that can be deducted cannot exceed the interest defined as qualified home mortgage interest. Generally, this is limited to the interest on total debt not to exceed $1,100,000 ($1,000,000 of basic debt and $100,000 of “home equity” debt). No more than two personal use residences may be combined for this computation.

If the damaged real estate turns into investment property, the “investment interest deduction limitation” would govern the deductibility of the interest.

The United States tax system is considered a voluntary compliance system. No tax collector comes to our door and goes through our records each year to determine the tax liability. We prepare a return and pay any tax due or request a refund for overpaid taxes. On occasion, after a return has been filed the IRS or state income tax authority may request additional information to substantiate (sometimes clarify) a position or resolve a reporting discrepancy.

In cases where the taxpayer has acted in good faith and made reasonable determinations in the preparation of the return only the additional tax and interest on the later payment will be assessed in most situations after a change has been determined. The law requires for most cases where there is a substantial underpayment the imposition of penalties on audit differences. If the tax authority determines that an unreasonable or unsupportable position has been taken to avoid the payment of taxes, additional substantial penalties can be imposed. In cases where a large adjustment is made to a tax return due to a faulty disaster loss deduction, the adjustment can be very large and therefore automatically trigger additional penalties.

Because the amounts involved in the settlement of an insurance claim and a possible disaster loss may be substantial, it is important that the reporting of the proceeds on a tax return be consistent with the documentation as well as the law and that the tax preparer be made aware of the details of the payments and other key amounts. Excessive estimates and unreasonable allocations and descriptions may result in audit adjustments, ending in substantial costs and penalties.

In some cases, the item will be a flag to the IRS on its own merits. In other cases, the tax return is simply selected at random for examination. In either cases if there is a substantial item related to the settlement of a casualty loss claim and the explanation on the return is adequate, there may be no call from the IRS to provide substantiation. However, if the item is not adequately disclosed and reported, the IRS will start by asking for additional information and then look for inconsistencies and discrepancies. This is not an area to be handled by an inexperienced person.

Several property tax issues arise after a catastrophic event. First, the remaining property is not “worth” as much as it was before the event. In the case of a complete loss, the structure no longer exists. In large-scale events involving a number of homes, the property tax assessor will likely make blanket revaluations to compensate for the destroyed improvements. Their reassessments are open to questioning by the homeowner. Once the improvements are replaced, the assessed values will be returned to the pre-loss values with normal adjustments that would have occurred.

In cases where the property has been held for long periods in a state such as California where there are only small annual adjustments to valuations unless the property is sold, it is possible that the assessed value before the event may still be lower that the value of the remaining land after the loss. In that case, there is likely no revaluation.

In most cases, the assessor assigns a split in the total valuation between land and structures that usually weighs the structure more heavily than the land. It is usually assumed the primary value is in the structure, not the land. Where site characteristics are valuable, the land may have a disproportionally higher value than the norm. When a catastrophic event strikes, the assessor may reduce or eliminate all of the value assigned to the structure, acknowledging that the structure has been destroyed. However, the land valuation remains, possibly because the assessor determines that the long-term value of the land itself has not been impacted. Unfortunately, the owner does not receive the tax reductions that may have been expected. After the catastrophe occurs, it is probably not the optimal time to challenge the assessor’s valuation split made in a year past. For this reason, when the assessor’s valuation split is first made, the owner should examine that allocation closely and if it is too heavily weighted toward the land, it may be worthwhile to challenge it immediately.

In California, over 30 years ago the electorate passed a referendum that placed serious limitation on the increase in the annual valuation of real estate. Subsequent referendums added additional benefits. One of them specifically addresses the situation where a taxpayer has experienced a major loss that has been declared a disaster by the governor. It is important to note that for this provision, it is the governor’s declaration that counts, a federal disaster declaration is not required. (A federal declaration can only be requested by the governor after a state declaration.) If the state has made the declaration then it is possible for a homeowner to transfer the pre-loss assessed value attributable to the damaged property to a replacement home. Generally, the replacement must be in the same county as the damaged property unless the county in which the replacement property is located has enacted an ordinance allowing for cross-county replacements. If the damaged property has not been sold at the time the replacement property is acquired it will continue to be assessed as it had been without the taxpayer having acquired replacement property.

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,