Were you or your loved ones impacted by the Los Angeles fires? The tax consequences associated with the lost property depend on whether or not the property was insured, or if the loss is compensated otherwise (e.g. by federal government).
Insured Real Property, Compensated Losses
If your house was lost to fire and was insured, you’ll be entitled to compensation. If the insurance proceeds exceed your adjusted basis in the property, you may have a capital gain. This can happen if your home appreciated in value since you purchased it and the insurance proceed exceeded the so-called adjusted basis in the property. In short, the adjusted basis equals the purchase cost increased by capital improvements, if any. [1]
If you generated a capital gain, you may qualify for the Section 121 exclusion, which allows you to exclude up to $250,000 ($500,000 for married couples filing jointly) of the gain. Section 121 of the Internal Revenue Code applies when certain ownership requirements are met. [2]
Section 1033 will apply in relation to the so-called involuntary conversion. An involuntary conversion occurs when property is destroyed in whole or in part or condemned, and you receive compensation such as insurance proceeds for the loss. Section 1033 states that no gain is recognized if you reinvest monetary compensation in a replacement home within a specified timeframe.
The timeframe is usually 2 years following the end of the year when the insurance proceeds (or other compensation) were received. [3] The timeframe is 4 years for a principal residence involuntarily converted because of a federally declared disaster. [4] On 1/9/25 President Biden approved a Major Disaster declaration for California. The qualifying replacement property should be “similar or related in service or use to the property so converted”.
Let’s consider an example of involuntary conversion exclusion. Personal-use property destruction in a federally declared disaster:
Personal-use property destruction in a federally declared disaster:
- Adjusted basis of property: $1,000,000.
- Insurance (or other) reimbursement: $1,600,000.
- Section 121 ownership requirements are met.
Insurance reimbursement was fully reinvested in building or purchasing a new house within 4-year timeframe.
Calculations:
- Capital gain = Insurance reimbursement ($1,600,000) less Adjusted basis ($1,000,000) less Section 121 exclusion ($ 250,000) = $350,000.
- Capital gain will not be recognized for tax purpose as exclusion requirements in Section 1033 were met.
If insurance proceeds were not reinvested in a qualifying replacement property, $350,000 will be subject to capital gain tax.
Personal Property
Proceeds for the loss of personal property (e.g., furniture, appliances, clothing, other general contents of a personal residence) are not taxable, provided they do not exceed the value of the lost property. Any gain on personal property, e.g., proceeds exceeding the original cost of the property could be taxable. Fo example, if you purchased a TV for $1,000. If you receive $1,500 from the insurance company for its loss, the $500 gain is taxable. However, if the loss occurs in a federally declared disaster area, insurance proceeds (or other compensation) for the property in question may be excluded from taxable income, even if the proceeds exceed the adjusted basis. [5]
If your insurance policy provides proceeds for temporary living expenses, those payments are generally not taxable as long as they reimburse actual expenses and do not result in a profit. If they exceed your actual costs, the excess might be taxable.
Reimbursement Basis, Insurance Terms
Note that reimbursement basis in some insurance policies is current market value of the property at the time of the loss, factoring in depreciation. In other words, the reimbursement will equal current market value of a similar used home, not new home. This basis is referred to as Actual Cash Value (ACV). Reimbursement referred to as Replacement Cost Value (RCV) is the cost to replace or repair the damaged property with a new item of similar kind and quality, without factoring in depreciation. This payout is generally higher than with ACV policies. Check your insurance policy to find out what terms apply to you. Your insurance policy will determine the amount of reimbursement. This amount will determine the amount of capital gain.
Uninsured Property, Uncompensated Losses
If a taxpayer’s property is lost, destroyed, or damaged and no insurance reimbursement or other compensation is received, the taxpayer may be able to deduct the adjusted basis of the property as a casualty loss on their tax return, subject to certain limitations and rules under the Internal Revenue Code. Specifically, the loss must be reduced by i) $100 per casualty event and ii) 10% of the taxpayer’s adjusted gross income (AGI). [6]
Before January 1, 2026, the loss can only be allowed if it is attributable to a Federally declared disaster. If the reduction in the fair market value of the lost property due to the loss event is lower, than property’s adjusted basis, the reduction in the fair market value should be used as a tax deduction. [7] Any loss occurring in a federally declared disaster may, at the election of the taxpayer, be deducted in the taxable year immediately preceding the taxable year in which the disaster occurred. [8]
Casualty losses are generally deducted as itemized deductions on Schedule A of Form1040. If the casualty loss exceeds your taxable income, it does not create a carryforward because itemized deductions cannot be carried forward on their own. [9]
Let’s consider an example.
Personal-use property destruction in a federally declared disaster:
- Adjusted basis of property: $150,000.
- FMV before loss: $180,000.
- FMV after loss: $0 (total destruction).
- Insurance (or other) reimbursement: $0.
- AGI: $100,000
- Taxable income $ 90,000
Calculations:
- Loss = Lesser of Adjusted Basis ($150,000) or Decrease in FMV ($180,000 – $0) = $150,000.
- Subtract $100: $150,000 – $100 = $149,900.
- Subtract 10% of AGI: $149,900 – (10% × $100,000 = $10,000) = $139,900 Deductible Loss.
However, since the taxpayer’s taxable income was $90,000, the deductible loss reduces taxable income to $0. The remaining $49,900 of the loss cannot be utilized or carried forward because it is related to personal-use property.
Footnotes:
[1] more specifically, taxpayers adjusted basis is determined as follows: cost paid for the land and the house+ closing cost + capital improvements +/- certain other items (e.g. prior insurance reimbursements, etc.). Section 1012, 1016.
[2] The requirement is that during the 5-year period the property has been owned and used by the taxpayer as the principal residence for periods aggregating 2 years or more. Note that according to Section 121(d)(b), “For purposes of this section, the destruction, theft, seizure, requisition, or condemnation of property shall be treated as the sale of such property.”
[3] Section 1033(a)(2)(B)(i)
[4] Section 1033(h)(1)(B)
[5] Section 1033(h)(1)(A)(i)
[6] Section 165(h)(1), Section 165(h)(2)(A)
[7] Treas. Reg. § 1.165-7(b)(1)
[8] Section 165(i)(1)
[9] Section 172(d)(4)
FinAcco Contacts:
NICK LARCHENKO, Managing Partner
646.713.4764 / nick.larchenko@finacco.org
POLINA LEUDANSKAYA, Accounting Advisory Director
877.734.6222 / polina.leuda@finacco.org
MARINA SHMATIKOVA, Tax Director
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Important Note: FinAcco is not responsible for, and no person should rely upon, any information presented in this publication. This and other publications are prepared for general purposes only and do not constitute tax advice. FinAcco does not assume any responsibility for timely updates of its website overall or any information provided in this publication, specifically.
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