On August 10th 2020, a ‘derecho’, an inland hurricane, ripped through Iowa causing severe damage to structures, landscapes, and crops. A federal disaster declaration was made by President Trump and includes the following counties in Iowa: Benton, Boone, Cedar, Clinton, Dallas, Jasper, Johnson, Jones, Linn, Marshall, Muscatine, Polk, Poweshiek, Scott, Story, and Tama. Along with these storms came a flood of insurance claims and left business owners wondering about the tax impact of related insurance proceeds, or lack thereof. The answer depends on whether the amount of insurance proceeds you receive puts you in a casualty ‘gain’ or ‘loss’ position.
To identify whether you are in a casualty gain or loss position, you must first identify the adjusted basis of the property that was damaged or destroyed. The adjusted basis of an asset is typically the price the asset was purchased for, plus improvements less any tax depreciation that has been taken on the asset over the years.
(Cost of asset and improvements – depreciation taken on asset ) = adjusted basis of property
If your insurance proceeds exceed your adjusted basis in the asset, you are in a casualty gain position. If your insurance proceeds are less than your adjusted basis in the asset, you are in a casualty loss position.
Casualty Gain = Insurance proceeds > adjusted basis of property
Casualty Loss = Insurance proceeds < adjusted basis of property
Due to the accelerated depreciation options available for many assets, which causes the adjusted basis of the assets to be reduced very quickly, casualty gains will be common amongst taxpayers and will be considered taxable unless an elected deferral is made.
Business and Investment Provisions
Involuntary Conversion Deferral (IRC Section 1033)
A taxpayer may elect to defer a casualty gain if they meet the requirements of an involuntary conversion under IRC Section 1033. An involuntary conversion is defined as the replacement of property that was lost in whole or part due to theft, seizure, condemnation, or destruction from a fire, earthquake, hurricane, or some other destructive event (i.e. a derecho).
In order to defer any gain under the involuntary conversion rules, the following requirements must be met:
- You must purchase replacement property (defined later) with the insurance proceeds within 2 years after the close of the taxable year in which the conversion happened. For calendar year taxpayers affected by the derecho, you will have until 12/31/2022 to use the funds.
- The replacement property cost must be equal to or greater than the insurance proceeds received.
- The replacement property must be one of the following:
- Any tangible property held for productive use in any trade or business (equipment, machinery, vehicles, inventory, etc.)
- Acquisition of stock in any trade or business the taxpayer will have 80% of the voting power and at least 80% of the total number of shares.
For example, Taxpayer A owns two different businesses that are not in the same industry. Property from one of its businesses is destroyed in a federally declared disaster area. Taxpayer A’s replacement property could be property for the business that suffered the loss, the other business it owns or any other business.
The above requirements for involuntary conversions and casualty losses are only for federally declared disaster areas.
For casualty gains and involuntary conversions that occur that are not related to a federally declared disaster area, the requirements are similar to those above except you the replacement property must be “similar or related in service or use to the property destroyed”; the replacement property cannot be for any property or for any trade or business. The replacement property does not have to be like-kind property (i.e. a tractor for a tractor); the scope of ‘similar’ property is broader and allows more options to taxpayers for replacement property.
If your insurance proceeds do not cover the adjusted basis of the property, you have a casualty loss. Taxpayers are allowed a deduction for casualty losses that are incurred in a trade of business. How much of a loss is allowable depends on whether the property was completely destroyed or if it was only damaged.
If the property is completely destroyed the casualty loss is equal to the difference between the adjusted basis of the property and the amount of insurance proceeds received.
Completely Destroyed Casualty Loss = Adjusted Basis – Insurance proceeds
If the property is damaged, not completely destroyed, the casualty loss is equal to the lesser of the adjusted basis or its decline in fair market value less the amount of insurance proceeds received.
Damaged Casualty Loss = (Lesser of adjusted basis or decline in FMV) – Insurance proceeds
Business casualty losses are determined on a property-by-property basis. Taxpayers are not allowed to aggregate their properties together when making the calculation.
Although not required, any casualty losses resulting from a federally declared disaster can be taken on the previous year’s tax return at the election of the taxpayer. An amended prior year tax return must be filed to do so.
Involuntary Conversion of primary residence
If you lost your primary residence in a federally declared disaster area, the same involuntary conversion rules apply – you are able to defer any gain realized from the conversion but instead of having 2 years to replace your home, you have 4 years to replace your home.
Taxpayers experiencing loss of personal use property in a federally declared disaster area have two limitations that apply to a casualty loss deduction:
- the loss must exceed $100,
- aggregate losses may be deducted only to the extent they exceed 10% of adjusted gross income.
Casualty losses that are not from a federally declared disaster area are not deductible.
Each taxpayer has a different situation and it is important that you discuss your specific situation with your tax advisor to make sure your situation meets the requirements necessary for the tax treatment you are hoping for. Contact our team for more information.