Alabama Tornado Assistance – Issue II

This issue will cover:

Casualty Gains

Involuntary Conversions – Business and Investment Property (reinvesting insurance proceeds)

Inventory Replacement

BRIC – Business Recovery Information Center

Gain Exclusion – Personal Residences and Property

Counties Covered By Presidential Disaster Declaration

Casualty Gains

While most taxpayers think of casualties as causing losses (which is more typically the case), in some situations gains may result from insurance payments in excess of the taxpayer’s basis in the damaged property. This newsletter will provide guidance on how to avoid or defer tax on gains which you may have as a result of the recent tornadoes and storms.

Tax on a casualty gain may be deferred under the involuntary conversion rules. If a taxpayer uses all of the insurance proceeds received from a casualty to purchase replacement property within a required time period, the casualty gain will not be taxed. However, the basis of the replacement property is reduced by the untaxed gain. Thus, the gain is deferred but not avoided; it is built in to the replacement property. There are special rules for personal residences that are destroyed that may not require replacement property to avoid gain.

We will discuss tax rules separately for business property and personal residences/other personal property.

Involuntary Conversions – Business and Investment Property

Taxpayers with business or investment property destroyed in the tornadoes/straight line winds of April 2011, may need to reinvest the insurance proceeds received for the property damaged to avoid taxation. There are special relief provisions that broaden the scope of the normal involuntary conversion rules that defer gain on the receipt of the insurance.

As a review of the normal rules, taxpayers may defer gains realized from involuntary conversions of property resulting from destruction, theft, seizure, condemnation or threat thereof. To defer the gain, the taxpayer must use all of the insurance proceeds to purchase property that is similar or related in service or use or to restore the property to its original usefulness. The replacement period (if the property is not located in a federally declared disaster area) begins on the earlier of the date the property was destroyed, stolen, condemned, etc. or the date of the act that caused the conversion and ends two years after the close of the taxable year in which any part of the gain from the conversion is realized. Therefore, if your business property was destroyed in the tornado on April 27, 2011 and you have a gain from the insurance reimbursement that you receive July 1, 2011, you have until December 31, 2013 to replace the property and defer the gain instead of needing to replace it by April 27 or July 1, 2013.

For federally declared disaster areas, the rules for involuntary conversions are less stringent. First, the IRS can extend the normal deadline for actions such as purchasing replacement property. During Hurricane Katrina, the replacement period was extended from three years to five years. These extensions are not automatic and the IRS will publish a notice or issue other guidance authorizing the postponement.

Secondly, the rules for what qualifies as replacement property are different for federal disaster areas. Under normal rules, replacement property must be substantially the same as the replaced property. In a federally declared disaster area, the similar use requirements are modified as follows:

• If the property destroyed was held for productive use in a trade or business or for investment, the replacement property can be property held for productive use in a trade or business even if it isn’t “similar-use property”.
• The replacement property cannot be property held for investment unless it is similar in use to the property destroyed. In other words, the replacement property cannot be unimproved real estate held for investment unless the property destroyed was also property held for investment.
• Property purchased for resale or as a personal residence can never satisfy the replacement property rules for business property that has been destroyed.

For example: A taxpayer held timber and land for investment purposes. The tornado destroyed the timberland located in a federal disaster area. The taxpayer decides to construct and open a restaurant. The new business property would qualify as replacement property in a federal disaster area. If the property destroyed was NOT in a federally declared disaster area, the taxpayer would be required to replace the timber and land with more timber and land or reforestation.

Inventory Replacement

Recently, the IRS issued a Technical Advice Memorandum (TAM) which addressed the issue of replacing inventory that has been destroyed. The TAM stated that if a taxpayer realized a gain on involuntary conversion of inventory, costs to construct a building were allowed as replacement property. Keeping in mind that this is just a deferral of gain – and not an exclusion of gain – this could be very valuable to a taxpayer. For example, if a taxpayer is required to purchase inventory as reinvestment for a gain on the involuntary conversion of inventory – their gain would probably be recognized within the year (or two) of purchase. If they can reinvest the proceeds into an asset such as a building – the gain is deferred for a much longer period of time (39 years for nonresidential real estate).

The State of Alabama follows all rules related to Involuntary Conversions – including the ones for federally declared disaster areas.

BRIC – Business Recovery Information Center

The Small Business Administration (SBA) is now available to assist area businesses and non-profit organizations with disaster loans at the recently established Tuscaloosa Business Recovery Information Center (BRIC) that has been set up by the Chamber and SBA. Businesses and private non-profit organizations of any size may borrow up to $2 million to repair or replace disaster damaged or destroyed real estate, machinery and equipment, inventory, and other business assets. SBA disaster loans will provide low interest rate loans for up to 30 years to help our business community recover.

Your business may be eligible for an economic injury disaster loan (EIDL) even if you had no physical damages. These loans are to help meet working capital needs caused by the disaster.

The filing deadline to return SBA applications for physical property damage is June 27, 2011. The deadline to return economic injury applications is January 30, 2012.

SBA Fact Sheet – Alabama Disaster Loans: http://www.sba.gov/sites/AL Declaration 12545 Fact Sheet

You can make an appointment to meet with an SBA Field Operations Specialist by calling 205-758-7588. Your JMF accountant would be glad to attend this appointment with you and assist you with disaster loan decisions.

Gain Exclusion – Personal Residences and Property

Where the property damaged was the taxpayer’s home it may be even easier to avoid tax on a casualty gain.

Homes Completely Destroyed – As you may be aware, if you used your home as your principal residence (not merely as a vacation home) for at least two years out of the previous five, you can exclude up to $250,000 of gain on its sale ($500,000 for married couples filing jointly). This exclusion cannot be used more than once in a two-year period.

These principal residence gain exclusion rules apply to gains from the destruction of the home as well. Thus, casualty gains of up to $250,000 ($500,000 for married couples) can be excluded from gross income if the destroyed property is a principal residence. This gain exclusion only applies if the home was completely destroyed. Factors indicating complete destruction include damage so extensive that it is not advantageous to use any remaining structure to restore the property or the cost of repairs substantially exceeds the home’s fair market value before the damage.

If the casualty gain on a home exceeds the amount of the exclusion, the excess amount can be deferred under the involuntary conversion rules. To defer the remainder of the gain, the cost of the replacement property need only be equal to the insurance proceeds minus the excluded amount.

Homes Damaged But Not Destroyed – If your home was damaged but not completely destroyed, you must reinvest the insurance proceeds received for the home to defer recognition of gain. Any insurance proceeds received for the residence or separately scheduled contents (jewelry, art, and other separately stated valuables) can be treated as a common pool of funds and can be reinvested in repairing the home or to replace contents of the home or both. You will have gain only to the extent that the funds received exceed the repairs and replacement cost.

You will have four years from the end of this year to use the insurance proceeds (as opposed to two years for normal involuntary conversions).

Here is an example: In May 2011, Taxpayers received a total of $200,000 for tornado damages to their residence and $10,000 for damage to their oriental rugs (separately scheduled under the insurance policy). Their house was damaged but not totally destroyed. Between now and December 31, 2015, the taxpayer spends $180,000 to repair the residence, $20,000 for furniture, $5,000 for clothing and $5,000 for a painting. Because the taxpayer spent $210,000 for replacement contents they will not have to recognize a gain upon for the receipt of the $210,000 of insurance proceeds.

Insurance for Personal Property – No gain is recognized for insurance proceeds received for personal property (unscheduled) that was part of the contents of your damaged personal residence regardless of the use of the proceeds. There is no requirement to reinvest or spend the insurance you receive for personal property.

The State of Alabama follows all rules related to Involuntary Conversions – included the ones for federally declared disaster areas.

Counties Covered By Presidential Disaster Declaration

On April 28^th the President declared a major disaster exists in the State of Alabama and ordered Federal aid to supplement State and local recovery efforts in the area struck by severe storms, tornadoes, straight-line winds, and flooding beginning on April 15, 2011, and continuing. The President’s action makes Federal funding available to affected individuals and businesses in the counties of Autauga, Bibb, Blount, Calhoun, Chambers, Cherokee, Chilton, Choctaw, Clarke, Colbert, Coosa, Cullman, DeKalb, Elmore, Etowah, Fayette, Franklin, Greene, Hale, Jackson, Jefferson, Lamar, Lauderdale, Lawrence, Limestone, Madison, Marengo, Marion, Marshall, Monroe, Morgan, Perry, Pickens, Shelby, St. Clair, Sumter, Talladega, Tallapoosa, Tuscaloosa, Walker, Washington and Winston (updated through 5/17/11) http://gis.fema.gov/maps/dec_1971.pdf.

For more information, please do not hesitate to contact JamisonMoneyFarmer PC at 205-345-8440. You can also visit our website at www.stg-zofavina-staging.kinsta.cloud to monitor updates.

ANY TAX ADVICE CONTAINED HEREIN WAS NOT INTENDED OR WRITTEN TO BE USED, AND IT CANNOT BE USED BY THE TAXPAYER, FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER. THIS DISCLOSURE IS REQUIRED BY CIRCULAR 230 ISSUED BY THE U.S. TREASURY DEPARTMENT.

2200 Jack Warner Parkway, Suite 300,Tuscaloosa, AL  35401 | 205-345-8440 | www.stg-zofavina-staging.kinsta.cloud | info@jmf.com