United States: The Silver Lining: Deferring Tax On Insurance Proceeds After Storms

The recent hailstorms and flooding throughout the Dallas, San Antonio and Houston areas1 serve as another unwelcome reminder that severe weather is a constant threat to Texas grape growers' crops and equipment as well as their bottom lines. While insurance proceeds can compensate for the damaged or destroyed property, grape growers might be unaware that these proceeds can produce a taxable gain. This article provides a brief overview of the income tax treatment of insurance proceeds for damaged or destroyed property, as well as a strategy grape growers can use to defer tax on their insurance recoveries.

If a taxpayer's insurance recovery for damaged or destroyed property is greater than the adjusted basis in the damaged or destroyed property, the taxpayer will have a taxable gain2 and must report the gain as income in the year the taxpayer receives the reimbursement.3 However, if the insurance recovery does indeed result in a gain, a taxpayer may be able to defer the gain (and avoid tax) under section 1033 of the Internal Revenue Code (I.R.C. §1033).

Section 1033 mandates nonrecognition if property (e.g., the insurance proceeds) is used to purchase property "similar or related in service or use" to the converted property.4 While neither the Code nor the regulations define the phrase "similar or related in service or use," the IRS focuses on whether there is "similarity in the relationship of the services or uses which the original and replacement properties have to the taxpayer-owner."5 Further, the Tax Court has stated that the "similar or related in service or use" standard requires:

  • that reinvestment be made in "substantially similar" property;
  • that reinvestment substantially continue the prior commitment of capital and not depart therefrom;
  • the character of the investment must remain the same, although the replacement property need not duplicate the converted property; and
  • that the entire transaction allows a taxpayer, whose enjoyment of property has been interrupted without his consent, to return as closely as possible to his original position.67

Further, if the property at issue is real property held for productive use in trade or business or for investment, the taxpayer can reinvest the insurance proceeds into property that is similar or related in service or use or into property that is "like-kind."8 The rules governing whether one piece of real property is like-kind to another are fairly generous. For example, improved property is considered like-kind to unimproved property, so a grape grower could reinvest insurance proceeds from damage to buildings used in his operations into additional acreage on which to grow grapes.

In order for I.R.C. §1033 to apply, property must be "compulsorily or involuntarily converted."9 Section §1033 is limited to cases in which property is destroyed, stolen, seized, requisitioned or condemned, or disposed of under the imminence of requisition or condemnation.10 Examples of "destruction" include destructions by weather,11 fire12 or pollution.13

Additionally, taxpayers should be aware that:

  • complete deferral is available only if the taxpayer reinvests the entire amount of monetary proceeds received in the conversion;14
  • a taxpayer who does not recognize gain generally takes a carry-over basis in the replacement property;15 and
  • the replacement period to purchase property begins on the date of the conversion16 and ends two years after the close of the first tax year in which any part of the gain upon the conversion is realized.17
  • Dealing with damage and destruction to crops and equipment from severe weather is a well-known cost of doing business for Texas grape growers. Fortunately, I.R.C. §1033 provides a silver lining for grape growers faced with the financial consequences from the unforeseen loss of business property.

Footnotes

1 Houston Flooding Could Cost Up to $1.9 billion, BBVA Compass Economists Say, http://www.prnewswire.com/news-releases/houston-flooding-could-cost-up-to-19-billion-bbva-compass-economists-say-300256077.html (last visited April 25, 2016); San Antonio Hail Storm Called Costliest in Texas History with Nearly $1.4 Billion in Losses, http://www.mysanantonio.com/business/local/article/San-Antonio-hail-storm-1-4-billion-in-losses-7269460.php (last visited April 25, 2016); Emma Orr and Sonali Basak, North Texas Hail Storms Now Doing Damage on Wall Street, Biz Beat Blog (Apr. 21, 2016, 11:03 am), http://bizbeatblog.dallasnews.com/2016/04/north-texas-hail-storms-now-doing-damage-on-wall-street.html/ (stating that two hail storms in March caused more than $1 billion in property damage in North Texas).

2 Hunter v. Comm'r, 10 T.C.M. (CCH) 298 (1951); I.R.S. Publ'n No. 547, pg. 67.

3 I.R.S. Publ'n No. 547, pg. 67.

4 I.R.C. §1033(a)(1).

5 See, e.g., Rev. Rul. 64-237, 1964-2 C.B. 319, 320; see also Liant Record, Inc. v. Commissioner, 303 F.2d 326 (2d Cir. 1962); PLR 200109005 (purchase of leased property used as a retail hardware store as replacement property for involuntarily converted property owned and used by the taxpayer as a retail hardware store qualifies for I.R.C. §1033).

6 Maloof v. Comm'r., 65 T.C. 263 (1975).

7 The following examples of replacement property have been found to be "similar or related in service or use" to the converted property: (1) improvements to retained farmland (see Rev. Rul. 271, 1953-2 C.B. 236); (2) a standing crop of grain and another standing or harvested crop of the same grain (Rev. Rul. 59-8, 1959-1 C.B. 202); and (3) improvements to remaining property to prevent recurrence of conversion (See Rev. Rul. 60-69, 1960-1 C.B. 294).

8 I.R.C. §1033(g)(1).

9 I.R.C. §1033(a).

10 Id.

11 See Rev. Rul. 195, 1953-2 C.B. 169 (holding that destruction of livestock by lightening constitutes I.R.C. §1033 "destruction;"); Rev. Rul. 59-8, 1959-1 C.B.202 (holding that destruction of wheat crop by hail constitutes I.R.C. §1033 "destruction").

12 But see Rev. Rul. 82-74, 1982-1 C.B. 110, in which the Service held that I.R.C. §1033 did not apply to a taxpayer who hired an arsonist to burn the taxpayer's building, because in order for I.R.C. §1033 to apply, the destruction must be outside the taxpayer's control.

13 Rev. Rul. 66-334, 1966-2 C.B. 302 (holding that pollution of a water supply is I.R.C. §1033 "destruction").

14 If only parts of the proceeds are reinvested, gain is recognized to the extent of nonreinvestment. I.R.C. §1033(a)(2)(A).

15 I.R.C. §1033(b).

16 Property acquired before the start of the replacement period will not qualify as replacement property.

17 I.R.C. §1033(a)(2)(B).

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