Tax law helps disaster victims

ARTICLE CONTENTS:

Recent Legislation

IRS Administrative Relief

Postponement of Time-Sensitive Acts

Exclusion for Qualified Disaster Relief Payments

Casualty Loss Deduction

• Amount of the casualty loss
• Repair costs as measure of casualty loss
• Reduction for insurance or other compensation

Casualty Loss Deduction Rules Unique to Individuals

• Loss for real property
• Losses for items of personal property
• $100 per-casualty floor for personal losses

Casualty Loss Deduction Rules Unique to Businesses

• Total destruction of property
• Basis of converted property
• Aggregating business properties for casualty loss purposes

Election to Deduct Disaster Losses in Preceding Year

• Making the election

Disaster Loss Presumption Where Home is Demolished

Eased Rules for Homes Damaged in Federal Disasters

Qualification for Reduced Home Sale Exclusion

Voluntary Sale of Remainder of Property After Portion is Destroyed/Condemned

• More liberal rule for residences

Liberal Replacement Rule for Destroyed Business Property

Deferral of State Disaster Relief Grant to Business

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The many victims of Hurricanes Harvey, Irma, and Maria, as well as other recent storms, doubtless are now preoccupied with salvaging what they can and seeing what their insurance will cover. When the extent of their losses becomes clear, victims will want to know what tax help they’re entitled to.

In addition to recent specifically targeted hurricane tax relief legislation and specific IRS administrative hurricane relief (both discussed below), relief is also provided in the current Code and regulations for disaster victims. Some of these provisions are available for the victim of any casualty, such as a storm or flood. Others are available only for those in a federally declared disaster area. This Practice Alert (in two parts) explains these relief provisions. This article deals with the postponement of time-sensitive acts; the exclusion for qualified disaster relief payments; the casualty loss deduction in general; and the casualty loss deduction rules that are unique to individuals and those that are unique to businesses.

Recent legislation.

On September 28, Congress passed the “Disaster Tax Relief and Airport and Airway Extension Act of 2017”, which would reauthorize the Federal Aviation Administration (FAA) for six months and deliver temporary tax relief to the victims of Hurricanes Harvey, Irma, and Maria. Tax provisions in the bill would make it easier for people with hurricane losses to write them off on their taxes, eliminating a requirement that personal losses must exceed 10% of adjusted gross income to qualify for a deduction. It would also give hurricane victims penalty-free access to retirement funds and temporarily suspend limitations on the deduction for charitable contributions to hurricane relief made before year-end. As we went to press, the bill was awaiting President Trump's expected signature. For a full discussion of the tax provisions in this bill:

IRS Administrative Relief.

Specific administrative hurricane relief granted by IRS includes:

• Providing taxpayers in federal disaster areas, including areas impacted by Hurricanes Harvey, Irma, and Maria, more time to make tax payments and file returns,
• Encouraging leave-based donation programs for victims of Hurricane Harvey, see Weekly Alert ¶ 7 09/07/2017 (Notice 2017-48, 2017-39 IRB) and Irma,).
• Allowing retirement plans to make loans and hardship distributions to Harvey victims, see Weekly Alert ¶ 30 09/07/2017 (Ann. 2017-11, 2017-39 IRB) and Irma victims,
• Providing relief to victims of Hurricanes Harvey and Irma in connection with certain employee benefit plans,
• Waiving the penalty that would otherwise apply when dyed diesel fuel is sold for use (or used) on the highway for areas affected by Hurricane Harvey (IR 2017-142), Hurricane Irma (IR 2017-149).
• Providing temporary relief to controlled foreign corporations moving inventory located in areas affected by Hurricane Irma and Hurricane Maria to the U.S. to escape damage, see (Notice 2017-55, 2017-42 IRB)
• Temporary relief from certain low-income housing tax credit requirements in order to facilitate emergency housing for individuals who are displaced from their principal residences, (IR 2017-165)

Postponement of Time-Sensitive Acts

Under Code Sec. 7508A, IRS may permit taxpayers affected by a disaster loss to postpone for a fixed period of time the filing of returns, the submission of tax payments, and the performance of other time sensitive acts. The postponement applies to “affected taxpayers”, which includes

1. Individuals whose principal residences are located in a disaster area,
2. Business entities or sole proprietors whose principal place of business is located in a disaster area,
3. Taxpayers who aren’t included in (1) or (2) but whose records necessary to meet the deadline for performing an act are located in a disaster area;
4. Any estate or trust that has tax records necessary to meet a filing or payment deadline in a covered disaster area; and
5. Any spouse of an affected taxpayer, solely with regard to a joint return of the husband and wife. (Reg. § 301.7508A-1(d)(1))

The complete list of possible postponements is carried in Rev Proc 2005-27, 2005-20 IRB 1050.

Exclusion for Qualified Disaster Relief Payments

Under Code Sec. 139, individuals may exclude a qualified disaster relief payment. Such a payment also isn’t earnings for self-employment tax purposes or wages for employment tax purposes.

A qualified disaster relief payment includes an amount (to the extent not compensated by insurance or otherwise) paid to or for the benefit of an individual:

1. To reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster (which includes a federal disaster),
2. To reimburse or pay reasonable and necessary expenses incurred to repair or rehabilitate a personal residence (including a rented residence) or repair or replace its contents to the extent that the need for the work results from a qualified disaster, and
3. If the amount is paid by a federal, state, or local government, or an agency or instrumentality of those governments, in connection with a qualified disaster in order to promote the general welfare (but not if payments are made to businesses or for income replacement or unemployment compensation).

IRS has ruled that the Code Sec. 139 exclusion applies to grants made by employers for unreimbursed medical, temporary housing and transportation expenses of employees who are affected by a flood that is a Presidentially-declared disaster. (Rev Rul 2003-12, 2003-1 CB 283)

Observation:

Effective for disasters declared in tax years beginning after Dec. 31, 2007, the term “federally declared disaster” replaced the previously used “presidential disaster area” term (see Code Sec. 1033(h)(3), as amended by Sec. 706(d)(1), Div. C, P.L. 110-343). The new term is substantially the same as the definition of “presidentially declared disaster” under former law. (T.D. 9443)

Other excludable payments.

IRS also has ruled that individuals who are victims of a flood that is a Presidentially declared disaster (now termed a “federally declared disaster”; see discussion above) may exclude:

1. State grants for unreimbursed medical, temporary housing and transportation expenses; and
2. Charitable grants. (Rev Rul 2003-12, 2003-1 CB 283)

Casualty Loss Deduction

Businesses as well as individuals that suffer losses as a result of a natural disaster such as Hurricane Harvey are entitled to deduct a casualty loss.
The manner of determining the amount of a casualty loss allowable as a deduction in computing taxable income generally is the same whether the loss was incurred in a trade or business, or whether it was a personal casualty loss. Determining the amount of a casualty involves finding the amount of the casualty loss, and reducing the casualty loss amount by insurance or other compensation.

There are rules that are unique to calculating the deduction for personal casualty losses, principally the $100 per casualty floor and the 10%-of-AGI floor. And there are some rules that are unique to casualty losses involving business or investment property, such as the special rule that applies if property is completely destroyed.

Amount of the casualty loss.

The amount of a casualty loss generally is the lesser of:

1. The difference in fair market value (FMV) of the property immediately before and immediately after the casualty (Reg. § 1.165-7(b)(1)(i)), or
2. The adjusted basis for determining loss from the sale or other disposition of the property. (Reg. § 1.165-7(b)(1)(ii))

Establishing drop in property’s FMV by appraisal.

The difference in FMV of property immediately before and after the casualty should be determined by competent appraisal. (Reg. § 1.165-7(a)(2)) The appraiser’s knowledge of sales of comparable property and conditions in the area, his familiarity with the damaged property before and after the casualty, and his method of determining the amount of the loss are important in proving the deductible amount. (IRS Publication 17, 2016, pg. 174) An appraisal must recognize the effects of any general market decline, i.e., a decline that would affect undamaged as well as damaged property, which may occur simultaneously with the casualty, so that the casualty loss deduction will be limited to the actual loss resulting from damage to the property. (Reg. § 1.165-7(a)(2))
Appraiser’s fees for valuing the amount of a casualty loss aren’t part of the casualty loss; they are treated as expenses of determining tax liability. Individuals deduct these fees as miscellaneous itemized deductions, subject to the 2%-of-AGI floor. (IRS Publication 17, 2016, pg. 174) Appraiser’s fees associated with trade-or-business casualty losses should be deductible as business expenses.

Repair costs as measure of casualty loss.

The costs of repairing, replacing, or cleaning up after the casualty aren’t, in themselves, deductible as casualty losses. (IRS Publication 547, 2016, pg. 5) However, the cost of repairs is acceptable evidence of the loss of value if the taxpayer shows that:

1. The repairs are necessary to restore the property to its condition immediately before the casualty,
2. The amount spent for repairs isn’t excessive,
3. The repairs don’t repair more than the damage suffered, and
4. The value of the property after the repairs doesn’t, as a result of the repairs, exceed the value of the property immediately before the casualty. (Reg. § 1.165-7(a)(2)(ii))

Where the taxpayer relies on the cost of repairs (and not a competent appraisal, see discussion above) to measure the amount of a casualty loss, the repairs and associated expenditures must actually be made. (See, e.g., Abrams, Paul, (1981) TC Memo 1981-231; Goodfriend, Marvin, (1986) TC Memo 1986-519)

Reduction for insurance or other compensation.

The casualty loss amount is reduced by the amount of any insurance, other compensation, or reimbursement received. (Code Sec. 165(a))

Reimbursement includes:

• Repairs, restoration, or cleanup provided by relief agencies (Instructions to Form 4684, Casualty Losses (2016), p. 3),
• The forgiven part of a federal disaster loan ((Instructions to Form 4684, Casualty Losses (2016), p. 3), Rev Rul 71-160, 1971-1 CB 75),
• The receipt of a debris removal reimbursement (Rev Rul 71-161, 1971-1 CB 76),
• Money received as an employee from an employer's emergency disaster fund to the extent the cash is used to replace damaged or destroyed property for which a casualty loss deduction is being claimed (IRS Publication 547, 2016, pg. 6), and
• Payments granted under a state eminent domain code to allow for full compensation to property owners for losses sustained when their residences were destroyed by flood. (Mager, Morris v. U.S., (1980, DC PA) 45 AFTR 2d 80-97945 AFTR 2d 80-979)

However, disaster relief such as food, medical supplies, and other forms of assistance doesn’t reduce the casualty loss unless they are replacements for lost or destroyed property. (IRS Publication 547, 2016, pg. 6)

Casualty Loss Deduction Rules Unique to Individuals

An individual’s deductions for casualty losses are subject to special rules regarding how the loss is calculated for realty and personal property. Additionally, each personal casualty is reduced by $100; all personal casualty, disaster and theft losses for the year are deductible by itemizers only to extent they cumulatively exceed 10% of adjusted gross income (AGI); and an additional 2% of AGI floor applies to “employee property”.

Loss for real property. When figuring a casualty loss on personal-use real property, an individual treats the entire property (including any improvements, such as buildings, trees, and shrubs) as one item. The loss is the adjusted basis of the property or the decrease in FMV of the entire property. (Reg. § 1.165-7(b)(2)(ii), IRS Publication 17, 1916, pg. 176)

Illustration: In 2014, Mr. Able bought his family’s home for $900,000. He planted trees and ornamental shrubs on the grounds at a cost of $12,000. In 2017, a hurricane damages the home, trees, and shrubs. At the time of the casualty, the adjusted basis of the entire property is $912,000 and its FMV value immediately before the casualty is $1,000,000. Immediately after the casualty the entire property’s FMV is $700,400. In 2017, Able receives $50,000 of insurance to cover the building damage. The amount of the loss (before application of the $100 floor and the 10%-of-AGI floor) with respect to the entire property (land, house, trees, and shrubs) for '97 is $249,600, calculated as follows:

• The difference in the FMV immediately before the casualty ($1,000,000) and the FMV immediately after the casualty ($700,400) is $299,600 (the amount of the property destroyed).
• The loss to be taken into account is $299,600 (lesser of $299,600 amount of property destroyed or $912,000 adjusted basis); and
• The $299,600 loss must be reduced further by the amount of insurance received ($50,000) to $249,600. (Reg. § 1.165-7(b)(3), Ex (2))

Losses for items of personal property.

Where more than one item of personal property held for personal use is damaged by casualty, the taxpayer, in computing the total loss, must determine the decrease in the FMV or adjusted basis of each item claimed to have been lost or damaged. These separate losses are then combined to determine the total loss resulting from the casualty. (Rev Rul 66-50, 1966-1 CB 40)

$100 per-casualty floor for personal losses.

A casualty (or theft) loss of personal use property is allowed only to the extent that the amount of the loss from each event exceeds $100. (Code Sec. 165(h)(1)) For purposes of this limit, events closely related in origin give rise to a single casualty. Thus, if a single storm damages a person’s house and car parked in his driveway, the loss is from a single casualty. (Reg. § 1.165-7(b)(4)(ii))

In general, where a loss from a single casualty is sustained in more than one year, only a single $100 reduction is required. The $100 floor applies to the entire loss from each casualty. (Reg. § 1.165-7(b)(4)(ii))

Where the same casualty (or theft) damages an item of property owned by two or more persons, the $100 floor applies separately to each person. (Reg. § 1.165-7(b)(4)(iii)) Only a single $100 floor applies with respect to any particular casualty in the case of a husband and wife if they file a joint return, whether the loss is to property jointly or separately owned. (Code Sec. 165(h)(4)(B); Reg. § 1.165-7(b)(4)(iii)) But if the spouses file separately, the $100 floor applies separately to each spouse even if the property is owned jointly. (Reg. § 1.165-7(b)(4)(iii))

If property is held for both personal and business (or profit) purposes, the $100 floor applies only to the personal part of the loss. (Reg. § 1.165-7(b)(4)(iv))
10%-of-AGI floor beneath personal losses. If a taxpayer has personal casualty losses but no personal casualty gains for a tax year, the losses are allowed as an itemized deduction only to the extent that they exceed 10% of the taxpayer’s adjusted gross income (AGI). (Code Sec. 165(h)(2)(A)) The 10%-of-AGI floor is applied only after each separate loss has first been reduced by the $100 floor. (IRS Publication 547, 2016, pg. 7)

Illustration 1: Sarah sustains an $25,000 casualty loss to her home in a tax year in which she has AGI of $120,000. The $100 per casualty floor reduces the deductible amount to $24,900. Since 10% of Sarah’s AGI is $12,000, the amount of the loss that’s deductible on Schedule A, Form 1040, is $12,900 ($24,900 – $12,000).

Illustration 2 This year, Fred’s home sustained $6,000 of damage from a spring flood and $8,000 in fall hurricane damage. If Fred’s AGI is $100,000, he can deduct only $3,800 of the loss: $14,000 less $200 ($100 per loss floor), less $10,000 (10% of AGI).
The following rules apply if the taxpayer has both personal casualty gains and losses for a tax year:

• Compare total gains to total losses after reducing each loss by reimbursements and the $100 floor. (IRS Publication 17, 2016, pg. 177)
• If personal casualty losses exceed personal casualty gains, the excess of the losses over the gains is subject to the 10%-of-AGI floor. (Code Sec. 165(h)(2)(A))
• If personal casualty gains exceed personal casualty losses, the excess of the gains over the losses is treated as capital gain, and the 10%-of-AGI floor does not apply. (Code Sec. 165(h)(2)(B); IRS Publication 17, 2016, pg. 177)

Observation: The taxpayer may be able to avoid a tax on casualty gains by taking advantage of the involuntary conversion rules.
2%-of-AGI floor. A casualty loss deduction for employee property—i.e., property such as an auto used in performing services as an employee—when added to other job expenses and most other miscellaneous itemized deductions on Schedule A (Form 1040), Schedule A, must be reduced by 2% of AGI. Casualty losses of employee property are not subject to the $100-per-casualty floor, or the 10%-of-AGI floor. (IRS Publication 547, 2016, pg. 7, IRS Publication 547, 2016, pg. 8)

Casualty Loss Deduction Rules Unique to Businesses

The manner of determining the amount of a casualty loss involving business property generally is the same as it is for personal property. (Reg. § 1.165-7(a)) However, the casualty loss rules for business property differ from the casualty loss rules for personal property in a number of ways (besides not being subject to the $100 or 10%-of-AGI floors that apply to casualty losses of personal property).

The key casualty loss rules that are unique to business property are summarized below.

1. Total destruction of property. If property used in a trade or business or held for the production of income is totally destroyed by casualty, the amount of the loss is the adjusted basis in the property, less any salvage value, less any insurance or other recovery or reimbursement. The decrease in the property's FMV is not taken into account. (Reg. § 1.165-7(b)(1)(ii); IRS Publication 547, 2016, pg. 4)
2. Basis of converted property. A taxpayer may own property that was converted from personal use to business use or income-producing use and then was destroyed or damaged by a casualty. In such a case, the FMV of the property on the date of conversion, if less than the adjusted basis of the property at such time, is used, after making proper adjustments in respect of basis, as the basis for determining the amount of loss. (Reg. § 1.165-7(a)(5))
3. Aggregating business properties for casualty loss purposes. A loss incurred in a trade or business is determined by reference to the single, identifiable property damaged or destroyed. Thus, where a business building with ornamental or fruit trees or shrubs suffers storm casualty damage, the decrease in value before and after the casualty is measured separately for the building and the trees. The loss is not measured by treating them together as an integral part of the realty. (Reg. § 1.165-7(b)(2)(i)) This method is mandatory for losses to business or for-profit property. (Carloate Industries Inc v. U.S., (1966, CA5) 17 AFTR 2d 5917 AFTR 2d 59)

Illustration: Several years ago, ABX Corp. bought land containing an office building. The purchase price ($3,600,000) was allocated between the land ($720,000) and the building ($2,880,000) for purposes of determining basis. After the purchase, ABX planted trees and ornamental shrubs on the grounds surrounding the building. This year, the building, trees, and shrubs are damaged by a hurricane. At the time of the casualty, the building’s adjusted basis was $2,640,000 and the trees and shrubs had a basis of $48,000. The building’s FMV immediately before the casualty was $2,800,000 and immediately after the casualty it was $2,080,000. The FMV of the trees and shrubs immediately before the casualty was $80,000 and immediately after the casualty it was $16,000. This year, ABX received $200,000 of insurance to cover losses to its building. Deduction for building. The building’s FMV immediately before the casualty ($2,800,000) less its FMV after the casualty ($2,080,000) is $720,000 (value of the property destroyed). The loss to be taken into account is $720,000 (lesser of the $720,000 of property destroyed or the $2,640,000 adjusted basis). The loss is reduced by the $200,000 insurance received, resulting in a deduction of $520,000. Deduction for trees & shrubs. The amount of the deduction allowable for the trees and shrubs is $48,000. The $80,000 FMV immediately before the casualty less the $16,000 FMV immediately after the casualty is $64,000 (value of the property destroyed). The loss to be taken into account is $48,000 (lesser of the amount of property destroyed ($64,000) or the adjusted basis in that property of $48,000). (Reg. § 1.165-7(b)(3), Ex (2))
Where realty is destroyed and there is damage only to the buildings, the computation of the before-and-after FMV is based on the improvements alone and doesn’t include the land. (Reg. § 1.165-7(b)(2)(i)) Thus, the deduction is limited to the adjusted basis of the building alone. (Keefer, Ray, (1975) 63 TC 596)

Election to Deduct Disaster Losses in Preceding Year

A taxpayer who suffers a disaster loss can take the deduction in the tax year in which the disaster occurs, or can elect to deduct the loss in the immediately preceding tax year. (Code Sec. 165(i)(1))

Observation: Claiming the disaster loss for the year before the loss occurred saves taxes immediately, without having to wait until the end of the year in which the loss was sustained. In some cases, the deduction may result in a net operating loss, which will bring a refund by a carryback to an earlier year. On the other hand, deducting the loss in the year the loss actually occurred may result in bigger tax savings if the taxpayer is in a higher bracket that year.

Observation: Because of the 10% AGI floor for deductibility, taxpayers weighing the value of an early disaster loss deduction must also consider the relative amounts of AGI they have or expect to have for the two tax years.

• Illustration 1: Jill lives in a county that is hit by severe flooding damage as a result of Hurricane Harvey and is designated a federal disaster area. The flooding caused $40,000 of uninsured damage to her home. Jill estimates that her AGI for 2017 will be $100,000; for 2016, it was $80,000. She had no personal casualty gains in either year. If Jill claims the loss on her 2017 return, the loss would first be reduced by the $100-per-occurrence floor to $39,900 and then reduced by 10% of her 2017 AGI ($10,000) to $29,900. If she files an amended return for 2016 and claims the loss in that year, the loss would be reduced by the $100 threshold to $39,900 and then reduced by 10% of her 2016 AGI ($8,000) to $31,900. That’s $2,000 more than the loss she could deduct in 2017.If Jill also sustained casualty losses in 2016, deducting the current loss in that year could magnify her deduction. For example, if she sustained a casualty loss of $8,000 in 2016 (exactly equal to 10% of her AGI for that year), then she could deduct $39,900 of her disaster loss by filing an amended return for 2016.

Making the election.

The election to deduct a disaster loss in the year before the year in which the loss occurs is made on or before the date that is six months after the unextended regular due date for filing the original return for the tax year in which the disaster actually occurs. (Reg. § 1.165-11T(f))
Observation: A calendar-year taxpayer has until Oct. 15, 2018, to amend his 2016 return to claim a casualty loss that occurs in 2017.

The return or claim should specify the name or description of the disaster that resulted in the loss, date or dates of the disaster that caused the loss, and the city, town, county, state and zip code where the property was located at the time of the disaster.

Recommendation: An individual taxpayer who suffers a casualty loss in 2017 but doesn’t need an immediate tax refund may find it preferable to wait until he or she files the 2017 return before deciding. Then the taxpayer can make an informed judgment as to which tax year produces the greater tax saving from the deduction and choose that year to claim the loss.

Taxpayers have 90 days in which to change their minds after making an election to deduct a disaster loss for the year before the year in which the loss occurs. The election becomes irrevocable after 90 days following the date the election was made. (Reg. § 1.165-11T(g))

Disaster Loss Presumption Where Home is Demolished

A taxpayer whose residence is located in a federal disaster area may deduct any loss attributable to the disaster as a casualty loss if (Code Sec. 165(k)):

1. The taxpayer is ordered by the state or local government in which the residence is located to demolish or relocate the residence,
2. The order is made no later than the 120th day after the date of the President’s determination that the area warrants federal disaster assistance, and
3. The residence was rendered unsafe for use as a residence because of the disaster.

Observation: Code Sec. 165(k) creates a conclusive presumption that certain losses attributable to a federally declared disaster are casualty losses for purposes of Code Sec. 165 and qualify for tax relief as disaster losses deductible either in the tax year in which the disaster occurred, or in the preceding year. The taxpayer doesn’t have to prove that the disaster loss qualifies as a casualty loss.

Observation: Losses under this rule are still subject to the $100 and 10%-of-AGI limitations.

• Illustration 2 Over a number of years, a series of hurricanes and generally severe winter weather cause extensive beach erosion in an area, resulting in a danger of flooding. This year, the President determines that the area a federal disaster area. In order to rehabilitate the area and protect its residents, the governor orders the demolition of certain residences which have been rendered unsafe for use as residences as a result of the beach erosion. Mark’s residence is affected by the governor’s order. He is entitled to a disaster loss deduction (which he can claim either on his return for the year the order was signed, or on the previous year’s return) attributable to the erosion leading to the demolition of his residence without having to prove that he suffered a casualty loss. Since damage to property caused by erosion might be considered damage from progressive deterioration which would not qualify as a casualty loss, Mark would probably not be entitled to any loss deduction but for Code Sec. 165(k)

Observation: Code Sec. 165(k) doesn’t say that the taxpayer’s residence must be his primary residence. Presumably, therefore, this provision also applies to a taxpayer’s vacation home or second home.

Eased Rules for Homes Damaged in Federal Disasters

The Code Sec. 1033 involuntary conversion rules generally provide that gain from an involuntary conversion is deferred if the proceeds of the converted property are timely reinvested in eligible replacement property (generally, property similar or related in service or use to the converted property).

Under Code Sec. 1033(h), a taxpayer whose principal residence or contents is compulsorily or involuntarily converted due to a federal disaster is entitled to the following tax breaks:

1. Gain realized from the receipt of insurance proceeds for unscheduled personal property (property in the home but not scheduled property for insurance purposes) is not recognized.
   Illustration 3: After a federally declared disaster, an insurance company reimburses policyholders a flat amount for spoilage of food stored in refrigerators and freezers due to loss of electricity. The policyholders aren’t required to itemize the spoiled food or file a claim. They recognize no gain if the reimbursement exceeds the original cost of the food.
2. Insurance proceeds for the conversion of the principal residence and any of its contents other than unscheduled personal property are treated as a common fund for purposes of the involuntary conversion rules.
   Illustration 4: Anne’s principal residence and all its contents were destroyed as the result of a federal disaster. The destroyed household contents included jewelry and sterling silverware, each of which was separately scheduled for insurance purposes. Anne received total insurance proceeds of $310,000 as compensation for the destruction of the residence ($300,000) and its scheduled contents ($7,000 for the jewelry and $3,000 for the silverware). Thus, Anne’s common pool of funds is $310,000. Within the replacement period for involuntarily converted property (see below) (she spends $300,000 to build a new residence, $40,000 to buy home furnishings and clothing as replacements for those lost in the disaster, and $10,000 to buy a painting to hang in the new residence. Only the painting was separately scheduled for insurance purposes. Anne did not replace the jewelry or silverware. Because Anne spent $350,000 to buy a replacement residence and contents, which is in excess of the $310,000 common pool of funds that she received, Anne will not be required to recognize any gain upon the destruction of the residence and its contents. (Rev Rul 95-22, 1995-1 CB 145)
3. The taxpayer gets a longer period of time in which to replace a principal residence under the Code Sec. 1033 involuntary conversion rules. In general, the replacement period ends four years (instead of the usual two years) after the close of the first tax year in which any part of the conversion gain is realized.
   Observation: Under Code Sec. 121(d)(5)(A), the involuntary conversion of a principal residence is treated as a sale for purposes of the up-to-$250,000/$500,000 Code Sec. 121 home-sale exclusion. However, any excess of the gain on the involuntary conversion over the available exclusion may be deferred under the involuntarily conversion rules. Under Code Sec. 121(d)(5)(B), the amount realized for purposes of the involuntary conversion rules of Code Sec. 1033 is the amount realized less the excluded gain.
   Illustration 5 When his long-time principal residence was involuntarily converted, George, a single taxpayer, received $350,000 for the property. George realized $300,000 of gain on the conversion, $250,000 of which is excluded under Code Sec. 121. George can avoid a current tax on the remaining $50,000 of realized gain if he timely purchases a replacement residence costing at least $100,000 ($350,000 amount realized less $250,000 excluded gain). Moreover, under Code Sec. 1033(b)(2), George’s basis in his new home would be reduced by only the $50,000 of gain that’s not taxed due to the involuntary conversion rules—there’s no reduction on account of the excluded gain on the old residence. Thus, if George timely purchased a replacement residence for $350,000, his basis in it would be $300,000.

Qualification for Reduced Homesale Exclusion

A taxpayer can exclude from income up to $250,000 of gain ($500,000 for certain joint filers) from the sale of a home owned and used by the taxpayer as a principal residence for at least 2 of the 5 years before the sale. (Code Sec. 121(a)) The exclusion doesn’t apply if, during the 2-year period ending on the sale date, the exclusion applied to another homesale by the taxpayer. (Code Sec. 121(b)(3))

Under Code Sec. 121(c), a reduced homesale exclusion may apply to a taxpayer who fails to qualify for the full homesale exclusion because he doesn’t meet the Code Sec. 121 two-out-of-five-year ownership and use rule, or previously sold another home within the two-year period ending on the sale date of the current home in a transaction to which the exclusion applied.

Under Code Sec. 121(c)(2)(B), the failure to meet either rule must result from the home being sold (or exchanged) due to

1. A change of place of employment,
2. Health, or
3. To the extent provided by regs, other unforeseen circumstances.

Under Reg. § 1.121-3(e)(2), unforeseen circumstances include the involuntary conversion of a residence, and a natural or man made disaster (or act of war or terrorism) resulting in a casualty to a principal residence. These events are treated as unforeseen circumstances whether or not the home is located in a federal disaster area.

Under these circumstances, the maximum gain that can be excluded is equal to the full $250,000 or $500,000 exclusion times a fraction having as its numerator the shorter of

1. Aggregate periods of ownership and use of the home by the taxpayer as a principal residence during the 5 years ending on the sale date, or
2. The period of time after the last sale to which the exclusion applied, and before the date of the current sale, and having 2 years (or its equivalent in months) as its denominator. (Code Sec. 121(c))
   Illustration 6: Arnold buys a house that he uses as her principal residence. Twelve months after the purchase, the home is destroyed by a hurricane and the insurance company pays him cash for the home. Arnold has not excluded gain under Code Sec. 121 on an earlier sale or exchange of property within the last two years. He is eligible to exclude up to $125,000 of the gain from the sale of his house (12/24 × $250,000).

Voluntary Sale of Remainder of Property After Portion is Destroyed/Condemned

An event such as a storm, flood, or hurricane may destroy only part of a taxpayer’s property, or a condemning authority may only acquire part of a larger unit, thereby forcing the owner either to find a substitute for the destroyed or condemned portion in the vicinity, or to dispose of the remainder and replace the entire unit. A voluntary sale of a portion of such a unit, if forced on the taxpayer as an incident to involuntary conversion of a part of his property, is, for tax purposes, treated as an involuntary conversion. (Masser, Harry, (1958) 30 TC 74130 TC 741, acq;Rev Rul 59-361, 1959-2 CB 183)

In general, a taxpayer can treat such a voluntary sale as incident to an involuntary conversion only if a two-pronged test is satisfied (Rev Rul 78-377, 1978-2 CB 208):

1. The involuntarily converted property reasonably can’t be adequately replaced; and
2. There must be a substantial economic relationship between the condemned property and the property sold so that together they constitute one economic unit.

To demonstrate that the second prong of the above test is satisfied, the taxpayer must show that the property sold could not practically have been used without replacement of the converted property. (Rev Rul 78-377, 1978-2 CB 208)

More liberal rule for residences: When the dwelling portion of a residence is destroyed, e.g., by a tornado, a later sale of the land portion of the residence within the replacement period for the property will be treated as part of a single involuntary conversion occurring on the date the dwelling was destroyed. This rule applies to a taxpayer’s principal residence, or a taxpayer’s second residence, such as a vacation home. (Rev Rul 96-32, 1996-25 IRB 5)

Observation: The rule treating land sold after the destruction of a principal or second residence as part of the involuntary conversion of the residence applies if the land is sold within the replacement period. There is no need for the sale to also satisfy the two-pronged test in Rev Rul 78-377, 1978-2 CB 208 (see discussion above).

Illustration 7: In 2017, Mr. and Mrs. Anderson’s principal residence was destroyed by Hurricane Harvey. Their adjusted basis in the home (building and land) was $100,000. In 2017, they receive $320,000 in insurance proceeds for the structure, but choose not to rebuild. Instead, they sell the land for $50,000 in 2018. Since under Code Sec. 121(d)(5)(A), the involuntary conversion of a home is treated as a sale for purpose of the Code Sec. 121 exclusion, their entire $270,000 gain ($320,000 insurance proceeds +$50,000 land sale proceeds – $100,000 adjusted basis) ought to be eligible for the up-to-$500,000 exclusion for marrieds filing jointly.
Observation: If there were any excess of gain on the overall involuntary conversion over the available exclusion, it may be deferred under the involuntarily conversion rules (see discussion above).

Liberal Replacement Rule for Destroyed Business Property

In general, no gain is recognized when property is compulsorily or involuntarily converted into property similar or related in service or use. (Code Sec. 1033(a)(1)) However, tangible property acquired and held for productive use in a trade or business is treated as similar or related in service or use to property that

1. Was held for investment or for productive use on a trade or business (including inventory), and
2. Was involuntarily converted as a result of a federally declared disaster. (Code Sec. 1033(h)(2))

Illustration 8: X Corp receives $20,000 in insurance proceeds for a production machine (in which it has a basis of $10,000) destroyed in a federally declared disaster. X Corp replaces the machine with a $20,000 delivery truck and does so on a timely basis (generally, within two years after the close of the first tax year in which any part of the gain on the involuntary conversion is realized). X Corp's $10,000 of gain due to the involuntary conversion is not recognized currently. Under the regular involuntary conversion replacement rules, X Corp would have had to replace with a production machine similar in service or use to the destroyed machine.
Observation: To be eligible for the treatment allowed by the above rules, the replaced property (i.e., the property that was converted as a result of a federally declared disaster) may be either property held for productive use in a trade or business or property held for investment. However, the replacement property must be tangible property held for productive use in a trade or business. It may not be intangible property, and it may not be property held for investment.

Deferral of State Disaster Relief Grant to Business

A state may have a program to reimburse uncompensated business losses for disaster-related damage to real and personal property. IRS has held that such a grant is not excludable if made to aid in the economic recovery of an area, and conditioned on qualifying businesses continuing operations for a minimum of 5 years in or near the area affected by the disaster. However, IRS said a business may elect under Code Sec. 1033 to defer the gain realized from receipt of the grant to the extent that an amount equal to the grant proceeds is used to timely purchase property similar or related in service or use to the destroyed or damaged property. (Rev Rul 2005-46, 2005-30 IRB 120)