Casualty Under The Internal Revenue Code—Part 3

Harold Goedde

This article is part 3 of a three-part series which discusses gains, including deferring the gain for income producing property by purchasing replacement property-qualifying property, time period for replacement, realized and recognized gain, and the basis of new property. The other 2 articles can be found by clicking on these links: Casualty Part 1 and Casualty Part 2.

Gains

 

Gains from casualties occur if the reimbursement exceeds the adjusted basis of the property destroyed, or decline in value for repairs in the case of a partial loss. For individuals, the gain is a capital gain and reported on Schedule D. Gains from casualties of business property are reported on Form 4797. If the asset was held one year or less, the gain will be reported as ordinary income in part II. If the asset was depreciable personal property, there will be depreciation recapture (ordinary income) under Section 1245, to the extent of the lesser of the gain or depreciation allowed or allowable.

The depreciation recapture is reported on Form 4797, Part II. If the asset was held more than one year, the balance of the gain, after depreciation recapture, is Section 1231 gain reported on Form 4797, Part 1. If the taxpayer is a corporation and the asset destroyed was a non-residential building depreciated using the straight line method, there is depreciation recapture under Section 291.

Note: for illustrations of the rules for depreciation recapture, see my article on Sales of Business Assets.

Deferring the Gain on Business Assets

 

A taxpayer may elect to defer the gain by reducing the cost of the replacement property by the lesser of the realized or recognized gain. The realized gain is the excess of the reimbursement over the adjusted basis of the asset if it is completely destroyed or the decline in value or cost of repairs if partially destroyed. The recognized gain is the difference between the replacement cost of the new property and the reimbursement for the loss of the destroyed property. Deprecation recapture applies to any recognized gain.

To defer the gain, the replacement property must be “like-kind” and acquired within two or three years depending on what type of property was destroyed. If the property was a personal residence located in a presidentially-declared disaster area, the replacement period is four years. The replacement period begins on the date of the loss and ends two, three, or four years after the end of the year in which the gain was realized. If a personal residence is destroyed and a gain is realized and the house is not replaced, all or part of the gain may be excluded under the sale of residence rules.

Business Assets—Acquisition of Replacement Property

 

If it is real property held by an owner-user or investor, replacement property must be acquired no later than three years after the end of the tax year in which the gain was realized (the year the proceeds for the condemnation are receive) [Sec. 1033(g)(4]. The replacement period begins at the end of the fiscal year, not the date the casualty occurred. It is not necessarily the same tax year the casualty occurred because the insurance proceeds may be received and the gain realized in the next tax year. If a taxpayer shows reasonable cause, an extension of the replacement period may be granted by the IRS but the request for an extension must be made before the replacement period expires [Reg.1.1033(a)-2(c)(3)].

Examples:

  • John owns a building used as a photo studio and has a fiscal year ending June 30. On 3/1/16, the building was destroyed by fire. On 6/15/16, the owner’s insurance paid him the fair value, which exceeded the adjusted basis, resulting in a realized gain. John has until 6/30/19 to replace the destroyed building with another building to be used as a photo studio (like-kind property)-three years from 6/30/16, the end of the fiscal year in which the building was condemned.
  • Robin has a fiscal year ending May 31. On 4/30/16, her grocery store was destroyed by a flood. On 6/15/ 16, her insurance paid the fair value which exceeded the adjusted basis, resulting in a realized gain resulting in a realized gain. Because the gain was realized in fiscal year 2016, to be able to defer the gain, she has until 5/31/2019 to replace the building and used as a grocery store.
  • Barb owns a condo held as rental property. Her tax year ends on December 31. On 2/1/16, the condo was destroyed by a tornado. On 6/1/16 her insurance paid the fair value which exceeded the adjusted basis, resulting in a realized gain. She has until 12/31/19 to acquire new real estate to be used as a condo for rental.

Business Assets—Qualified Replacement Property

 

The replacement property must be similar to or related in service or use to the property destroyed [Sec. 1033(a); Reg. 1.1033(a)-1]. What is qualified property depends on the type of property (personal or real) and its use (trade or business or as an investment as a lessor). The replacement test may also be satisfied by purchasing at least 80% of the voting stock of a corporation that owns the replacement property [Reg. 1.1033(a)-2(c)(1)].

Functional Use Test

 

Under this test, the replacement property must be used for the same purpose as the condemned property. This does not apply to real property used in a trade or business or any property held by an owner-investor (for example, rental property).

Like-kind test

 

This test applies to real property held for investment or used in a trade or business. Like-kind means the replacement property only has to be real property held by an owner-investor or owner-user [Regs. 1.1031(a)-1(a) and 1.1033(g)-1(a)]. Under the Sec. 1031 like-kind rules, improved real property can be replaced with unimproved real property or unimproved real property can be replaced with improved real property. But this code section has been overruled by Reg. 1.1033(a)-2(c)(9). This regulation states that there is no investment in similar property devoted to similar use if (1) the proceeds from condemnation of unimproved real property are invested in improved real property, or (2) proceeds are used to reduce debt previously incurred to purchase property.
Unproductive real property held for future use cannot be held as inventory [Sec. 1033(a)(2)(B); Reg.1.1033(a)-2(c)(3)].

Determining Deferred and Recognized Gain

 

The deferred gain is the excess of the realized gain over the recognized gain. The recognized gain is the lesser of (1) the realized gain or (2) the money received that exceeds the cost of the new property, assuming the property is replaced within the requisite time period. If it is not \replaced within the requisite time period or an extension is not obtained, the realized gain will be ordinary income in the year the replacement time period expires. To defer the entire realized gain, the replacement property must cost as much or more than the proceeds from the casualty. The basis of the replacement property is its cost less the deferred gain. The holding period of the old property carries over to the new property [Sec. 1233(1)(A)]. If the property was held for more than 12 months any recognized gain is Section 1231. If held 12 months or less, the recognized gain is ordinary income. If a Section 1231 gain results, there may be depreciation recapture (ordinary income) if the condemned property is personal property depreciated using any method. If real property is depreciated using the straight-line method and the owner is a corporation, there is depreciation recapture under Sec. 291.

Purchase of Similar Property

 

When a gain is realized, and a taxpayer elects to defer it by purchasing qualified replacement property within the prescribed time period (see above), part or all of the realized gain may be recognized depending on the cost of the replacement property. If the property was depreciable real property, some of the recognized gain will be ordinary due to depreciation recapture. The holding period of the old building is tacked on to the new building.

Examples:

1. Cost of new building exceeds money received:

On 1/1/2010 Surf and Turf, Inc. purchased a building for $300,000 to use as a seafood restaurant in Albany, NY. They took straight-line depreciation over 30 years. On 6/30/16, the restaurant was destroyed by a fire and the company received $430,000 from the insurance company. On 7/1/16, a similar replacement building to be used as a sea food restaurant was purchased for $600,000. The adjusted basis of the old building on 6/30/16 was $255,000 (300,000 – 45,000 accumulated depreciation). The realized gain, recognized gain, and basis of the new building is shown below:

Realized Gain:

 

Money received

$430,000

Adjusted basis of old building

$250,000

Realized Gain

$175,000

Recognized Gain:

Money received

$430,000

Cost of New Building

$600,000

Recognized Gain

$0

*No gain is recognized because the new building cost more than the money received.

Basis of New Building:

Replacement Cost

$600,000

Less Deferred Gain

$175,000

Total

$425,000

2. Cost of new building is less than money received: The holding period for the new property begins on 1/20/2010, the acquisition date of the property destroyed.

Assume the same facts as Example 1, except the new building cost $400,000. Since the entire proceeds were not reinvested, part of the realized gain will be recognized.

Recognized Gain:

Money received

$430,000

Cost of New Building

$400,000

Recognized Gain

$30,000

The holding period for the new property begins on 1/20/2010, the acquisition date of the property destroyed.

Dr. Goedde is a former college professor who taught income tax, auditing, personal finance, and financial accounting and has 25 years of experience preparing income tax returns and consulting. He published many accounting and tax articles in professional journals. He is presently retired and does tax return preparation and consulting. He also writes articles on various aspects of taxation. During tax season he works as a volunteer income tax return preparer for seniors and low income persons in the IRS’s VITA program.

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