Have You Used Your Insurance Proceeds From The California Wildfires?

Natural disasters like the California wildfires alter the laws of the tax universe for those who lose property in them. Knowing the rules can save money and heartache when dealing with a natural disaster that has effected your Del Mar homes, or properties that you may own in the greater San Diego area.

Changes to the tax code in recent years give people far more time to rebuild a Del Mar home and deal with tax issues. That can be a big help. And owners of Del Mar homes can now use insurance money more freely to rebuild without triggering taxes.

For many, the big questions after a disaster are: How can I use my insurance proceeds, when do I have to report this to the Internal Revenue Service, and what do I have to pay tax on? A law that enacted IRS Section 1033(h) in 1993 changed the rules on some of this following a devastating firestorm in Oakland, Calif., giving disaster victims a boost.

"It starts with insurance," said Anna Maria Galdieri, a certified public accountant in Oakland who worked closely with federal and state officials to change tax laws after the fires there in 1991. "It's really understanding what the policy covers and then what the tax law will allow you to do with the dollars you receive."

Taxes may be owed if the insurance company pays out even one dollar more than the cost basis of the house, or if the money isn't used to rebuild and replace property appropriately.

Tax-speak for the treatment an insured person can get in a natural disaster is an "involuntary conversion"; it is used when you have a gain from insurance that you don't expect to report as income because you're going to use the cash you received to replace the property.

An involuntary conversion gives even more leeway if the disaster is declared federally. In that case, the homeowner gets four years to reinvest certain insurance proceeds to replace the home and its contents if he has realized a gain. For example, if the cost basis of the house is $200,000 and the homeowner gets a partial insurance payment of $200,001 in June 2008, he has until Dec. 31, 2012, to reinvest and report the gain. If it is too hard to meet the four-year deadline, one can apply for a year-by-year extension to reinvest.

President Bush declared seven California counties -- Los Angeles, Orange, Riverside, San Bernardino, San Diego, Santa Barbara and Ventura -- federal disaster areas.

Eventually, the taxpayer figures a gain or loss based on the cost basis in the home and the insurance settlement. No loss can be taken until the taxpayer knows the final settlement, and the financial equation should include the proceeds of a lawsuit if the taxpayer files one against the insurance company.

In insurance lingo, household contents -- furniture, artwork, and the like -- are either "scheduled" or "unscheduled" items.

Scheduled items are covered by an insurance rider that lists and values them separately. Otherwise, items are seen as unscheduled personal property; insurance money recovered for them is tax-exempt when received as the result of a presidentially declared disaster.

Funds received for the house, other structures and scheduled personal property are seen as a common pool; they can be used to rebuild the home and replace its contents, according to Ms. Galdieri.

It is worth noting, too, that a disaster victim has more freedom now to reinvest insurance money recovered for lost business property. A person who ran a coffee stand before the new law was passed would have to use insurance to replace it with another coffee stand. Now, one could use the money to buy, say, computer equipment to set up a word-processing business.

Meanwhile, nothing needs to go on the tax form until one receives insurance payments that exceed the basis of the house. Nonetheless, says Ms. Galdieri, it can't hurt to write a note on the back of Form 1040 explaining that your house was destroyed and that you haven't yet received insurance payments.

If a taxpayer realizes a gain under the involuntary conversion and doesn't include it on the tax return, the IRS assumes the person has elected to defer the gain. The agency requires one to attach a statement to the tax return or write a letter to the district director of the IRS notifying it that the replacement has been completed and calculating the basis in the new home.

 

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