FAQs for victims of Hurricanes Katrina, Rita and Wilma (8/13/08) Provide examples of how the casualty loss, reimbursement and non-recognition of gain rules apply to taxpayers who sell their principal residences that were destroyed by Hurricane Katrina, Rita or Wilma. Example 1 (reimbursement in year of casualty) Facts The taxpayer’s house, which was his principal residence, was totally destroyed by hurricane Katrina in 2005. The residence was partially insured. The taxpayer’s pre-casualty basis in the property is $215,000. The taxpayer purchased the residence in 1999. The fair market value of the property immediately before the casualty is $300,000. The fair market value of the property immediately after the casualty is $100,000. The reduction in value of the taxpayer’s property as a result of the casualty is $200,000 and less than the taxpayer’s basis. To determine the allowable casualty loss, the taxpayer takes the lesser of the reduction in value of the taxpayer’s property or the taxpayer’s basis in that property, and then reduces this amount by any compensation or reasonable expectation of compensation for the loss by insurance or otherwise. In 2005, the taxpayer reasonably expects an insurance reimbursement of $50,000. Because of this reasonable expectation of reimbursement for part of the reduction in the property’s value the taxpayer’s casualty loss deduction is reduced from $200,000 to $150,000. In 2005, the taxpayer deducts a portion of the $150,000 casualty loss and carries back the remainder of the loss to prior tax years. The taxpayer partially rebuilds the house with the $50,000 insurance reimbursement. In 2006, the taxpayer sells the entire property to a third party for $150,000. Tax consequences The taxpayer’s basis in the property is reduced by the amount of the insurance reimbursement, but then, when the taxpayer uses the insurance reimbursement to rebuild the residence, the amounts expended increase the taxpayer’s basis in the property. Here, the taxpayer’s basis drops to $15,000 as a result of the $150,000 casualty loss deduction and the insurance proceeds of $50,000. The taxpayer’s basis increases to $65,000 when the insurance proceeds are spent on rebuilding the property. When the taxpayer sells the property in 2006, the gain is $85,000, the difference between the sales price received, $150,000, and the taxpayer’s basis after the rebuilding of the property, $65,000. The total destruction of the house which was the taxpayer’s principal residence and the taxpayer’s subsequent sale of the property are treated as part of a single involuntary conversion of the principal residence in 2005. The destruction of the residence and the sale of the entire property are treated as a single sale of the principal residence in 2005, for purposes of section 121. Accordingly, the gain from the sale of the entire property may be excluded from the taxpayer’s income under section 121. This result is the same if the sale of the entire property occurs in 2008 or 2009. If, under different facts, the taxpayer did not meet the requirements of section 121, the recognition of the gain could be deferred as an involuntary conversion if the requirements of section 1033 are met. Example 2 (casualty loss, sale to Louisiana Recovery Authority (“LRA”) for less than casualty loss and basis) Facts The taxpayer’s house, which was his principal residence, was totally destroyed by hurricane Katrina in 2005. The residence was not insured. The taxpayer’s pre-casualty basis in the property is $215,000. The taxpayer purchased the residence in 1999. The fair market value of the property immediately before the casualty is $300,000. The fair market value of the property immediately after the casualty is $100,000. To determine the allowable casualty loss, the taxpayer takes the lesser of the reduction in value of the taxpayer’s property or the taxpayer’s basis in that property, and then reduces this amount by any compensation or reasonable expectation of compensation for the loss by insurance or otherwise. In 2005, the taxpayer deducts a portion of the $200,000 casualty loss and carries back the remainder of the loss to prior tax years. The taxpayer does not rebuild the residence but sells the property in 2006 to the LRA for $150,000. The fair market value of the property at the time of the sale to the LRA is $100,000. Tax consequences The taxpayer’s taxable income for 2005 and prior years is reduced by $200,000 because of the casualty loss, and the taxpayer receives tax refunds based upon the reduced taxable income in those years. The taxpayer’s basis is reduced by the $200,000 casualty loss to $15,000. Upon the sale of the entire property to the LRA, because the property has a fair market value at the time of the sale of $100,000, the first $100,000 of the LRA payment is treated as being received in exchange for the property and represents gain to the extent it exceeds the taxpayer’s basis in the property. Here the taxpayer’s basis has been reduced by the casualty loss to $15,000 and consequently $85,000 of the first $100,000 received is gain on the sale of the property. Since the LRA payment exceeds by $50,000 the fair market value of the taxpayer’s property at the time of the sale, this portion of the payment is intended to compensate the taxpayer for the loss caused by the hurricane. Because the $50,000 payment represents a partial recovery of the casualty loss deduction that reduced the taxpayer’s tax in prior years, the taxpayer must report this amount as ordinary income on the 2006 tax return under the “tax benefit” rule. The taxpayer is required to report income under the “tax benefit” rule under the facts above for any payment designed to compensate the taxpayer for the loss caused by the hurricane, even if the program is limited to low-income taxpayers. A recent change in the tax law allows a homeowner who claimed a casualty loss for damage from hurricane Katrina, Rita, or Wilma, and in a later tax year received a certain grant such as an LRA Road Home grant as reimbursement for the loss, to amend the tax return on which the individual claimed the casualty loss to reduce the loss by the amount of the grant. If the individual carried back the casualty loss to prior taxable years, then the individual would also amend the tax return or returns to which the loss was carried back. See the section entitled “Grant Proceeds” in the FAQs for hurricane victims for more information on this change in the tax law. Also see, Notice 2008-95, Notice to Address Amended Returns for Hurricane-Related Casualty Losses and Subsequent Grants Reimbursing Such Losses. As in Example 1, the total destruction of the house, which was the taxpayer’s principal residence and the taxpayer’s subsequent sale of the entire property are treated as part of a single involuntary conversion of the principal residence in 2005. The destruction of the house and the sale of the entire property to the LRA are treated as a single sale of a principal residence in 2005, for purposes of section 121. Accordingly, the gain from the sale of the entire property to the LRA may be excluded from the taxpayer’s income under section 121. This result is the same if the sale of the entire property occurs in 2008 or 2009. If, under different facts, the taxpayer did not meet the requirements of section 121, the recognition of the gain could be deferred as an involuntary conversion if the requirements of section 1033 are met. The exclusion of gain under section 121, or deferral of gain under section 1033, does not apply to the amount recognized as income under the “tax benefit” rule. Example 3 (Casualty gain, sale to LRA for less than basis) Facts The taxpayer’s house, which was his principal residence, was totally destroyed by hurricane Katrina in 2005. The residence was insured. The taxpayer’s pre-casualty basis in the property is $215,000. The taxpayer purchased the property in 1999. The fair market value of the property immediately before the casualty is $300,000. The fair market value of the property immediately after the casualty is $60,000. To determine the allowable casualty loss, the taxpayer takes the lesser of the reduction in value of the taxpayer’s property or the taxpayer’s basis in that property, and then reduces this amount by any compensation or reasonable expectation of compensation for the loss by insurance or otherwise. In 2005, the taxpayer receives a $250,000 insurance payment as compensation for the property damage caused by the hurricane. Because the compensation received for the loss exceeds $215,000 (the lesser of the reduction in value of the property or the taxpayer’s pre-casualty basis). The taxpayer does not report a casualty loss on the 2005 tax return. The taxpayer does not rebuild the residence but sells the entire property in 2007 to the LRA for $50,000. Tax consequences The taxpayer realizes $35,000 gain upon receipt of the insurance proceeds in 2005 (the difference between the $250,000 payment received and taxpayer’s basis of $215,000) and does not have a casualty loss. Additionally, the taxpayer realizes an additional $50,000 of gain upon the sale of the property to the LRA in 2007, for a total realized gain of $85,000. As in Examples 1 and 2, above, the total destruction of the house that was the taxpayer’s principal residence and the taxpayer’s subsequent sale of the entire property to the LRA are treated as part of a single involuntary conversion of a principal residence in 2005. The destruction of the house and the sale of the entire property to the LRA are treated as a single sale of the principal residence in 2005, for purposes of section 121. Accordingly, the gain from the insurance proceeds and the sale of the entire property to the LRA may be excluded from the taxpayer’s income under section 121. This result is the same if the sale of the entire property occurs in 2008 or 2009. If, under different facts, the taxpayer did not meet the requirements of section 121, the recognition of the gain could be deferred as an involuntary conversion if the requirements of section 1033 are met. Example 4 (casualty loss, sale to unrelated party for less than basis) Facts The taxpayer’s house, which was his principal residence, was totally destroyed by hurricane Katrina in 2005. The residence was not insured. Taxpayer’s pre-casualty basis in the property is $215,000. The taxpayer purchased the property in 1999. The fair market value of the property immediately before the casualty is $300,000. The fair market value of the property immediately after the casualty is $25,000. To determine the allowable casualty loss, the taxpayer takes the lesser of the reduction in value of the taxpayer’s property or the taxpayer’s basis in that property, and then reduces this amount by any compensation or reasonable expectation of compensation for the loss by insurance or otherwise. In 2005, the taxpayer deducts a portion of the $215,000 casualty loss and carries back the remainder of the loss to prior tax years. The taxpayer does not rebuild the residence but sells the property in 2007 to an unrelated party for $25,000. Tax consequences The taxpayer’s adjusted basis in the property following the casualty loss deduction is $0; accordingly, the taxpayer realizes $25,000 gain upon the sale in 2007. As in the Examples above, the total destruction of the house that was the taxpayer’s principal residence and the taxpayer’s subsequent sale of the property are treated as part of a single involuntary conversion of the principal residence in 2005. The destruction of the house and the sale of the entire property are treated as a single sale of a principal residence in 2005, for purposes of section 121. Accordingly, the gain from the sale of the entire property may be excluded from the taxpayer’s income under section 121. This result is the same if the sale of the entire property occurs in 2008 or 2009. Since the sale proceeds were not reimbursements for the casualty loss, the $25,000 is not required to be included in the taxpayer’s gross income under the “tax benefit” rule. If, under different facts, the taxpayer did not meet the requirements of section 121, the recognition of the gain could be deferred as an involuntary conversion if the requirements of section 1033 are met. Example 5 (casualty gain, sale to unrelated party for less than basis) Facts Taxpayer’s house, which was his principal residence, was totally destroyed by hurricane Katrina in 2005. The residence was insured. Taxpayer’s pre-casualty basis in the property is $215,000. The taxpayer purchased the property in 1999. The fair market value of the property immediately before the casualty is $300,000. The fair market value of the property immediately after the casualty is $60,000. To determine the allowable casualty loss, the taxpayer takes the lesser of the reduction in value of the taxpayer’s property or the taxpayer’s basis in that property, and then reduces this amount by any compensation or reasonable expectation of compensation for the loss by insurance or otherwise. In 2005, the taxpayer receives a $250,000 insurance payment as compensation for the property damage caused by the hurricane loss. The taxpayer does not rebuild the house but sells the entire property in 2007 to an unrelated party for $75,000. Tax consequences The taxpayer realizes a gain of $35,000, following receipt of the 2005 insurance proceeds of $250,000 ($250,000 receipts in excess of $215,000 basis). The taxpayer does not have a deductible casualty loss, since he received reimbursements in excess of basis. Additionally, the taxpayer realizes an additional gain of $75,000 upon the sale of the entire property in 2007, for a total realized gain of $110,000. As in the Examples above, the total destruction of the house that was the taxpayer’s principal residence and the taxpayer’s subsequent sale of the entire property are treated as part of a single involuntary conversion of the principal residence in 2005. The destruction of the house and the sale of the entire property are treated as a single sale of a principal residence in 2005, for purposes of section 121. Accordingly, the gain from the insurance proceeds and the sale of the entire property may be excluded from the taxpayer’s income under section 121. This result is the same if the sale of the land occurs in 2008 or 2009. If, under different facts, the taxpayer did not meet the requirements of section 121, the recognition of the gain could be deferred as an involuntary conversion if the requirements of section 1033 are met.
