Home Destroyed
When a home is destroyed in a casualty or disaster the outcome can be quite different than expected by taxpayers. The reason being that their loss is measured from the lesser of the home’s adjusted basis or the FMV at the time of the loss. Since real property generally appreciates in value, for tax purposes a home that’s destroyed will generally result in a casualty gain as opposed to a casualty loss once insurance payment is considered. However, the gain can be excluded under Sec 121 if the taxpayer qualifies and any remaining gain (up to the basis of a replacement home acquired) can be deferred under the involuntary conversion rules of Sec 1033 (see page 7.11.06). In the case of a disaster loss, the replacement period ends four years after the close of the first tax year in which any part of the gain is realized. This is best explained by example.
Example: A wildfire in a disaster area destroys Phil's home which had an adjusted basis of $125,000. Phil is single and has owned and used the home for over 10 years before it was destroyed. Phil's insurance company pays Phil $400,000 for the house. A tax los is different from a financial loss in that a tax loss is measured from the lesser of the home's adjusted basis or the FMV at the time of the loss. So in this case Phil does not have a tax loss, he has a gain.
The destruction of Phil's home is treated as a sale for tax purposes and since Phil meets the 2 out of the 5 years ownership and use tests, the Sec 121 gain exclusion will apply. In addition, any gain in excess of the amount excluded can be deferred under Sec 1033. Here is how it all plays out for Phil...
| Insurance company payment | $400,000 |
| Phil's adjusted basis in the home | <125,000> |
| Realized Gain | 275,000 |
| Sec 121 Gain Exclusion | <250,000>* |
| Remaining Gain | 25,000 |
| Phil elects to defer gain into replacement | <25,000>** |
| Net taxable gain | 0 |
*Since the disaster was treated as a sale, presumably Phil would be qualified for another $250,000 Sec 121 exclusion after owning and using the replacement property for two years.
** Per Sec 1031 deferral, this amount reduces the basis of Phil's replacement home. This is an election and Phil could instead choose to pay the tax on the gain instead of deferring it. In addition, the deferral cannot reduce the basis of the replacement property below zero; thus, any amount not deferred would be taxable.