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Insure yourself against a tax catastrophe

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in Small Business Tax,Small Business Tax Deduction Strategies

Hurricane season has begun, summer brush fires have plagued the West and other parts of the country are likely to be hit by other natural disasters this summer.

Advice: Make sure you've secured adequate insurance for personal assets. If assets such as your home are damaged by a catastrophic event, you can claim a casualty loss on your tax return. But the deduction won't make you "whole" like insurance will.

Reason: You can deduct casualty losses to personal assets (as opposed to business assets) only to the extent the loss exceeds 10 percent of your adjusted gross income (AGI) (after subtracting $100 per casualty).

For instance, if your home's damage is estimated at $10,000 and your AGI is $120,000, you get no deduction. That's because the loss is less than 10 percent of your AGI. In contrast, you may receive replacement value, or an amount close to it, from an insurance policy.

What happens if the insurance proceeds exceed your basis in the property? In that case, you must report a taxable gain under the rules for involuntary conversions.

Example: Your house, which has a basis of $200,000, is destroyed in a fire. You're reimbursed $250,000 under your insurance policy. Normally, you would have to pay tax on a $50,000 gain.

However, you can avoid this harsh result if you reinvest the insurance proceeds in the home or similar property. Suppose you pour the extra $50,000 into improvements when your house is rebuilt. New result: You're not taxed on the excess insurance proceeds until the home is sold. And, when that happens, the gain may be sheltered by the $250,000/$500,000 home-sale exclusion.

Tip: You don't have to give up the insurance money right away. The tax law allows you to avoid taxable gain if you reinvest the proceeds within two years.

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