Gains on Involuntary Conversions
Norman M. Golden, EA
Like me, you may have clients, friends or family who suffered total or partial destruction to their property from the 2017 and 2018 fires in Northern and Southern California. We reach out to them on many levels. Certainly, it all starts on a personal basis, but eventually, they will turn to us as their tax advisors.
As I talked with many of my clients who suffered from the fires, and watched people interviewed on the television news, I was happy to hear that their first concerns were about being safe. At the same time, I was heartbroken by the stories of the loss of their homes and personal property that they had for many years. Depending on each person’s circumstances, some will have gains and some will have losses. A session at CSEA's Super Seminar would need two to four hours to properly cover all the possibilities of casual gains and losses, and there is no time and not enough space to cover them properly in this short article. I, therefore, want to focus on nonbusiness casualty gains.
An involuntary conversion occurs when your property is destroyed, stolen, condemned, or disposed of under the threat of condemnation and you receive other property or money in payment, such as insurance or a condemnation award. A taxpayer will realize a gain on an involuntary conversion if the amounts received from insurance or other sources exceed the adjusted basis in the property. It doesn’t matter what the Fair Market Value of the property was.
For example, my client, Dan, had a residence in Paradise, CA. On November 8, 2018 the Camp Fire devastated the town and destroyed Dan’s home with an adjusted basis of $100,000 and his personal effects with an adjusted basis of $10,000. Dan receives $310,000 from the insurance company ($300,000 for the house and $10,000) for his loss; his gain is $200,000. Dan tells me that that isn’t fair. I tell Dan that it’s my job to tell him what he needs to know. I also tell him it’s my job to tell him that, under Internal Revenue Regulation §1.1033(a)-2, if by December 31, 2020 (the end of the second year following his loss) he uses the $10,000 of insurance month and purchase property similar to his lost personal effects, he will be able to defer the gain. Dan says that helps, but what about the house. I tell Dan that it’s even better. Because the President approved a Major Disaster Declaration on November 12, 2018 for the State of California, Dan has until December 31, 2022 (the end of the fourth year following his loss) to use the $300,000 to replace his residence and be able to defer his gain.
Dan now tells me that he may move to another town or downsize his replacement residence and asks what if he doesn’t use the entire $300,000. The amount not used will result in a long-term capital gain from the casualty, but then he could exclude that gain under §121, the exclusion of gain from the sale of a principal residence. Dan says I think of everything, and I tell him that’s because I’m an Enrolled Agent!
Norman M. Golden, EA became an Enrolled Agent in 1995 and immediately joined the California Society of Enrolled Agents (CSEA) and the Golden Gate Chapter. He operates his tax practice in San Mateo, CA. He served as President of CSEA for the 2005-2006 term. He is still active in CSEA.