PROCESS
OF RECOVERING FROM A CATASTROPIC LOSS
INCOME
AND PROPERTY TAXES CONSEQUENSES AND REQUIREMENTS
PART
4
14 INSURANCE
vs. INCOME TAX
15 THINGS CAN GET WORSE
16
CHANGES AND “CORRECTIONS”
17 PART
PERSONAL USE / PART BUSINESS – IRS Rev. Proc. 2005-14
14 INSURANCE
vs. INCOME TAX
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.
15 THINGS
CAN GET WORSE
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.
NOT REPORTING A GAIN
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.
PROPERTIES
TAXPAYER DECIDES ARE NOT ACQUIRED AS REPLACEMENT PROPERTIES
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.
NOT REPORTING A LOSS
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.
DEATH
OF AN OWNER
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
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.
16 CHANGES
AND “CORRECTIONS”
CIRCUMSTANCES CHANGE
CHANGE OF MIND
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.
TAXPAYER DECIDES TO REINVEST AFTER TAX
HAS BEEN PAID ON A GAIN:
· “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.
RECOVERING
A PRIOR LOSS DUE TO ADDITIONAL PROCEEDS RECEIVED:
• “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.
CORRECTIONS:
· 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
SPECIAL
EXCLUSION OF GAIN SECTION 121 TRANSACTIONS:
MIXED USE PROPERTIES AND PARTIAL USE OF SECTION 121
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.
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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
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Certified
Public Accountant
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2975
E. Hillcrest Drive #403
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Thousand
Oaks, CA 91362
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(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 & 2013, John Trapani, CPA,
