Many business owners are surprised to learn that the receipt of an insurance recovery for a fire or other casualty loss may result in taxable income. This can occur where the amount of the insurance recovery exceeds the business’s depreciated tax basis in the destroyed property. Fortunately, there is a way to minimize or eliminate this problem: the federal tax rules generally permit businesses in these situations to reduce or eliminate taxable gain by reinvesting the insurance proceeds in so-called "similar use" property. In this scenario, taxable gain is generally recognized as the amount of insurance proceeds that are not used to purchase the replacement property. The character of any recognized gain will generally be ordinary income to the extent of "depreciation recapture" gain, with the remaining gain taxable as capital gain.
To illustrate how this works in practice, imagine that your company purchases an automobile for $30,000, and several years later the car is totaled in an accident when its depreciated tax basis is $15,000. Your company receives a check from the insurance company for $20,000, which was the vehicle’s fair market value at the time of the accident. The "gain" on this insurance recovery is $5,000 -- the difference between the insurance recovery and the car’s depreciated tax basis. If your company does not replace the destroyed vehicle, then the company will have to include $5,000 of taxable gain on its tax return for the year of the recovery. In this example the gain would be taxed as "depreciation recapture" ordinary income.
Things are much rosier, however, if your company decides to purchase another vehicle to replace the car that was lost. For example, if your company pays $20,000 for a new vehicle within the required replacement period, and elects non-recognition of gain treatment, then the company will not be required to report the “gain” from the insurance proceeds on its taxes. This reduces the company’s taxable income by $5,000 compared with the scenario above. In this scenario, the tax basis in the new vehicle would be $15,000, which is its $20,000 cost minus the $5,000 unrecognized gain on the insurance recovery.
The tax benefits can be significant even if your company does not use the entire $20,000 insurance recovery to purchase a new vehicle. For example, if your company spends $18,000 on the new vehicle, the company would be required to recognize $2,000 of “gain,” the difference between the insurance recovery and the cost of the replacement vehicle. That is a savings of $3,000 in taxable income. In this case the tax basis of the replacement vehicle would be $15,000, which is its $18,000 cost minus the unrecognized gain of $3,000.
A business desiring non-recognition treatment for a casualty loss insurance recovery must elect this treatment on its tax return for the year of the recovery. To qualify, the IRS rules generally require that the replacement property be "similar or related in service or use" to the property destroyed, or controlling stock of a corporation owning such property. This may require special scrutiny where the loss involves multiple types of assets, or where damaged or destroyed real estate is being replaced by new real estate with a somewhat different use.
The replacement property must generally be purchased within a two year period beginning at the end of the year of the insurance recovery, though the IRS will sometimes grant extensions. The replacement period may present special problems where the replacement property will be newly-constructed real estate. Construction must be paid for and completed by the replacement period's end. Merely paying the contractor for future construction is not enough. Also, the execution of a binding contract to purchase replacement property will not be sufficient if legal title, possession and control do not pass within the replacement period.
Navigation of the rules permitting non-recognition of "gain" on the receipt of a fire or other casualty loss recovery may be somewhat more complex than is suggested by this brief overview. For more information, please contact Warner Norcross & Judd tax expert Jay A. Kennedy at 248.784.5180. For questions about any insurance matter, please contact Joe Kuiper, chair of our Insurance Practice Group, at 616.752.2481.