Disaster tax tips: roadmap of changes to tax code

California CPA, Dec, 2004 by Anna Maria Galdieri

The inadequacy of many disaster-related federal tax regulations became apparent after the 1991 Oakland firestorms. As affected communities began to pick up the pieces, they also fought to reform several areas of the tax code. Much of the work done to help the Oakland fire victims gave those affected by the Southern California fires in October 2003 clear guidance on many of the issues they face in rebuilding.

In the wake of wildfire season, the following disaster-related tax issues can help reduce the burden on disaster victims--and ensure that the CPAs advising them achieve the desired tax results.

FEMA APPRAISAL

Uninsured disaster victims can use the Federal Emergency Management Agency appraisal of their loss to document their tax loss, a code section that was enacted after the Northridge earthquakes of 1994 [Sec. 165(i)(4)]. No loss can be taken until reimbursement claims have been settled.

THE MEASURE OF THE LOSS

The measure of the loss is the lesser of the decline in fair-market value or adjusted basis, not replacement cost.

Insured disaster victims often present me with a list of household contents they have valued at replacement cost because that is the number the insurance company uses. While the IRS will want to limit the value to thrift store values, the courts have allowed taxpayers to rebut that assumption and prevail.

REPLACEMENT COST

Insured disaster victims may have an economic loss if their insurance companies won't settle with them for the replacement cost of their real and personal property. They generally don't have a tax loss because the depreciated value of their contents is less than their insurance proceeds. Policy reformation is possible and disaster victims should work with organizations such as CARE and United Policy Holders to ensure a fair settlement.

SEC. 121 EXCLUSION

Homeowners who are insured and lose their principal residence in a federally declared disaster area can take their Sec. 121 exclusion against the gain realized. The money they receive for their contents is tax exempt [Sec. 1033 (h)(1)].

Many Southern California disaster victims are married and proposed insurance recoveries are less than $500,000. Since the exclusion wipes out the gain, when disaster victims rebuild or purchase a replacement home, their tax basis is equal to their replacement cost. If disaster victims sell their replacement home within two years of purchasing or rebuilding it, their gain is only the appreciation that's occurred since they replaced their home.

Because a natural disaster is considered an unforeseen circumstance, disaster victims who lived in their homes less than the requisite two years are able to take a partial exclusion thanks to the efforts of members of the AICPA's Residential Tax Task Force.

REINVESTING PROCEEDS

Insured disaster victims who lose tangible personal property used in their trade or business or held for investment can reinvest their proceeds in any tangible personal property. This relief came out of the Oklahoma bombings [Sec. 1033(h)(2)]. So, someone who lost a coffee stand, for example, can spend their insurance money to start a contracting business.

VACATION HOMES

Insured disaster victims who lose their vacation homes do not have the same benefits as disaster victims who lose their principal residences. They must reinvest their real and personal property dollars in a home and contents, or pay tax on the gain. Whether they can avail themselves of the common pool of funds theory of Sec. 1033(h)(1)(A)(ii) is yet to be determined (Rev. Rul. 95-22).

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TRADE/BUSINESS/INVESTMENT PROPERTY

Insured disaster victims who lose real property held for use in their trade or business or for investment are held to a stricter standard for reinvestment under Sec. 1033(a) than property owners who lose their property through condemnation under Sec. 1033(g).

Under Sec. 1033(g), a property owner who loses rental property can reinvest in a building that is like-kind, which is a broader definition than the functionally similar or related in service or use criterion of Sec. 1033(a). This distinction is without merit.

REINVESTMENT PERIOD

Homeowners who lose their principal residence and realize a gain in excess of their Sec. 121 exclusion have four years to complete the reinvestment.

Homeowners who lose their vacation homes have two years and owners of real property used in their trade or business or held for investment have three years. I'm working with the IRS to obtain a consistent reinvestment period for all Southern California wildfire victims.

EXTENSION REQUESTS

Disaster victims who cannot reinvest within the requisite time frame can request an extension from the IRS.

BY ANNA MARIA GALDIERI, CPA

Anna Maria Galdieri, CPA is an Oakland-based sole practitioner and chair of the Disaster Tax Subcommittee of CalCPA's Committee on Taxation. You can reach her at amgaldieri@pacbell.net.