In the Fall 2004 Legal Update, I wrote about some tax deductions available to those that incurred uninsured losses as a result of the recent Florida hurricanes. This article focuses on a related topic; the taxation of the receipt of insurance proceeds for insured losses with respect to property damaged or destroyed as a result of the recent Florida hurricanes.
Under the Internal Revenue Code, when property is damaged or destroyed by a natural disaster, such as a hurricane, and the owner recovers insurance proceeds for such loss, the owner is generally subject to income tax on the difference, if any, between the amount of the insurance proceeds received and the owner’s basis in the property, which is commonly referred to as “conversion gain.” However, there is an exception to this rule that allows the owner to elect to defer the taxation of the conversion gain if the insurance proceeds are timely used to purchase qualified replacement property.
The conversion gain is not subject to current taxation but is instead deferred because the owner’s basis in the replacement property is equal to the cost of the replacement property, decreased by the amount of conversion gain. Thus, when the replacement property is subsequently sold, the lowered basis results in greater gain. The price for deferring the conversion gain is that the lowered basis in the replacement property results in decreased depreciation deductions on the replacement property.
Qualified replacement property is generally defined as property that is “similar or related in service or use” to the property that was damaged or destroyed. This is a broad standard and the particular facts and circumstances of each property damaged or destroyed must be carefully analyzed to determine whether it can be satisfied. Examples of qualified replacement property include the following: (1) making substantial repairs to the damaged property to restore lost capacity; (2) planting new crops to replace destroyed crops; and (3) the purchase of a manufacturing plant to replace a long-term lease on a similar plant. Real property used in a trade or business (other than real property primarily held for sale) or held for investment does not need to satisfy the similar or related in service or use standard. Instead, the replacement property only needs to be of a “like-kind” to the damaged or destroyed property. Examples satisfying this like-kind standard, which is more liberal than the similar or related in service or use standard, include the following: (1) raw land replacing an apartment building; (2) commercial property replacing agricultural property; and (3) real property held for use in a trade or business replacing property held for investment.
The definition of qualified replacement property becomes even broader in the case of business or investment property that is damaged or destroyed as a result of a Presidentially declared disaster, such as the four hurricanes that recently struck Florida. This type of property does not need to be replaced with property that is similar or related in service or use, or that is of a like-kind. Instead, the replacement property will be deemed to be similar or related in service or use provided it is tangible property held for productive use in any trade or business.
Special rules apply when insurance proceeds are received because of damage or destruction to a principal residence. When this occurs, the owner can generally exclude up to $250,000 ($500,000 if the owner is married and filing a joint return) of conversion gain. If the total conversion gain exceeds this exclusion amount, the owner may defer taxation of the excess conversion gain by timely purchasing qualified replacement property that satisfies the similar or related in service or use standard. If, however, the principal residence was damaged or destroyed by a Presidentially declared disaster, no conversion gain is taxable by reason of the receipt of insurance proceeds for personal property that was part of the contents of the residence and that was not separately scheduled property for insurance purposes. This is true regardless of the use to which the owner puts the insurance proceeds. All other insurance proceeds received for such residence or its contents are treated as a common pool of funds received for the damage or destruction of a single item of property. In order to defer taxation of the conversion gain, these funds must be used to purchase property that is similar or related in service or use to either the damaged or destroyed residence or any of its contents.
In order to defer the taxation of conversion gain, the owner must acquire qualified replacement property within a certain time period. This time period generally begins on the date the property is damaged or destroyed, and generally ends two years (or four years in the case of a principal residence damaged or destroyed by a Presidentially declared disaster) after the close of the first tax year in which the insurance proceeds are received by the owner.
Even if the insurance proceeds are timely reinvested in qualified replacement property, complete deferral of the taxation of the conversion gain is possible only if the entire amount of the insurance proceeds are reinvested. If only a portion of the insurance proceeds are reinvested, the conversion gain is subject to current taxation to the extent of the non-reinvestment.