Involuntary Conversion of a Principal Residence

In Texas natural disasters sometimes happen. Thankfully, we are not often subject to earthquakes or tsunamis. However, we unfortunately are no stranger to the catastrophic force of tornados, floods, and occasionally hurricanes. If natural disasters do destroy your home or business, you will likely receive compensation from insurance. Everyone finds this safety net comforting. However, what most people do not consider are the tax consequences of insurance distributions. If the insurance distribution is greater than the amount paid for the property, it can create a taxable gain. Fortunately, there are two favorable provisions in the tax code that, if used properly, can be used to either permanently exclude gain recognition or temporarily defer it.

The first provision, Section 121 is known by many homeowners. This provision allows a permanent exclusion of up to $250,000 ($500,000 if married filing jointly return) of gain from the sale or exchange of a principal residence. Note that the tax code considers a destruction from unforeseen circumstances as a “sale or exchange.” The taxpayer must have lived in the home as a principal residence for two or more years within the five-year period before the home was destroyed. Note that the property must be completely destroyed.

The second provision, Section 1033 allows a taxpayer to defer gain realized from the destruction of property if destroyed or condemned. Although there is no dollar limit on the amount of gain that can be deferred, there is a hitch. The taxpayer must purchase or build a replacement property as a substitute for the destroyed property within two years from the end of the tax year that the taxpayer realized the gain, AND the taxpayer must elect to defer the gain.

Sections 121 and 1033 may be used together or separately if the taxpayer does not elect to utilize Section 1033.

Many taxpayers do not actually realize a gain from the destruction of their property either because they had no insurance, or the insurance was inadequate to cover the losses. In these circumstances, there is no gain realized so no need for consideration of Sections 121 and 1033. Unfortunately, most taxpayers receive no tax benefit from this sort of loss. If the loss occurs in a federal declared disaster area, the taxpayer can deduct the loss but only after a reduction of $100 per event and can only be deducted to the extent that the loss is in excess of 10% of the taxpayer’s Adjusted Gross Income. Yikes!

These provisions can be very tax beneficial under the right circumstances. We have published an extensive article on the ins and outs of these provisions. The article is free to the public. Read it here https://www.thetaxadviser.com/issues/2019/apr/involuntary-conversion-principal-residence.html

These provisions are extremely complicated. If you have questions about these provisions or other tax planning opportunities, please reach out to me at [email protected].


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