Did Hurricane Sandy or some other natural disaster damage your property last year? To add insult to injury, you may be liable for tax to the extent that insurance reimbursements or condemnation awards exceed your adjusted basis in damaged or destroyed property. This is known in tax lingo as an “involuntary conversion.”
Strategy: Repair the property or replace it quickly. If you meet the deadlines, you may defer the taxable gain with a special tax return election.
To qualify, expenditures should generally be made within two years of the close of the tax year in which the involuntary conversion occurred. A three-year period applies if the property is condemned. In either case, you can ask for an extension if you have extenuating circumstances.
Complex rules apply to business and investment property owned in an area designated as a federal disaster area. See your tax pro for details.
Here’s the whole story: If damaged property is converted directly into a replacement property, the taxable gain is automatically deferred. But you’ll normally receive insurance company cash instead. Thus, 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 replacement property costs less than the amount received as compensation (see box below). The basis in the new property is reduced by the amount of the deferred gain.
Tip: The deferred gain on an involuntary conversion is recognized when the replacement property is sold or exchanged.