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HOW YOUR BUSINESS INSURANCE RECOVERY IS TAXED

June 17, 2008

You've been hit hard by the floods and storms. The building with your business was wiped out. You paid $200,000 for the building long ago. After depreciation, the building basis was only $50,000. The building had gone up in value and was insured for $1,000,000, and the insurance company is writing you a check for the whole amount.

What does it mean for your taxes?

The tax law normally treats a business casualty loss as an "involuntary conversion." The insurance proceeds are normally taxable, but Sec. 1033 lets you avoid current tax if you invest the insurance proceeds in "like-kind" property by the end of the second year following the year the recovery is paid. The tax law allows you exclude gain if you reinvest the insurance proceeds in property "similar or related in service or use," but only if you file an election under Sec. 1033.

What does "similar or related in service or use" mean? Unfortunately, the tax law is fuzzy on this. If you invest the proceeds in continuing the same business that you were in before, that should be fine. If you decide to invest in a different line of business, that can be trouble.

The requirements for tax deferral are easier for businesses in a presidentially-declared disaster area. Such taxpayers only need to re-invest insurance proceeds in tangible property to be used in any trade or business, under the special rule of Sec. 1033(h)(2).

The catch? To the extent you avoid recognizing gain under the Sec. 1033 involuntary conversion rules, you don't get basis for the property purchased with the insurance proceeds. The taxpayer who used $1,000,000 in proceeds to buy a building and equipment, and who elected not to pay tax on the proceeds, would only get to depreciate the $50,000 basis that was in the old building. What are the rules for depreciating the replacement property? We'll save that for another post.

Links:

IRS Publication 547, Casualties, Disasters and Thefts

IRS 2007 Disaster Losses Kit for Businesses.

List of Iowa's Presidentially-declared disaster areas.

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