Did you suffer damage to business or rental real estate property from Hurricane Irene or some other natural disaster this year? At least you may be partially compensated for your troubles through insurance proceeds or a condemnation award. But such payoffs can be a double-edged sword.
Reason: Under a little-noticed tax law provision, you have a taxable gain to the extent the amount received from insurance coverage exceeds your adjusted basis in the property. This is known in tax parlance as an involuntary conversion.
Strategy: Fix up the property or replace it as soon as you can. As long as you meet certain timing requirements, you may defer the taxable gain by making a special election on your tax return.
To qualify for this tax deferral break, expenses should generally be incurred within two years of the close of the tax year in which the involuntary conversion occurred. A three-year period applies in situations where the property is condemned. In either case, you can apply for an extension. (Note: Taxpayers who were victimized by Hurricane Katrina were granted five years to complete repairs.)
Special favorable rules apply to property owned in an area designated by the president as a federal disaster area. See your tax pro for details.
Qualifying for tax deferral
Here’s the whole story: If the damaged property is converted directly into a replacement property, the taxable gain is automatically deferred. But things rarely go so smoothly in the real world. Normally, the property is converted into cash before it is used for the necessary expenditures. Therefore, you must comply with the tax law requirements to qualify for tax deferral.
Even if you elect tax deferral on the return for the year in which the damage occurred, you still must report a taxable gain to the extent that any replacement property costs less than the amount you receive as compensation. The basis in the new property is reduced by the amount of the gain that is being deferred.
If you have already reported the tax on a gain from an involuntary conversion, you can make the tax return election and obtain a refund. This can be accomplished by reinvesting the insurance proceeds within the two-year period (or longer if an extension has been granted) and filing an amended return within the statute of limitations.
Note that the tax deferral rules don’t apply to losses. Finally, unlike damage to personal assets, a loss to a business or investment asset is fully deductible (see box below).
Tip: The deferred tax on an involuntary conversion will be realized when the property is sold or exchanged.