Tax consequences on insurance payouts

[Michinori Kaneko]

Hello, 

I am trying to figure out the tax consequences on insurance payouts as I'm thinking about having a more tightly secured portfolio.

Lets say that the house has adjusted cost basis of $200k.  The options for insuring the properties are fair value approach or full replacement cost. The fair value you can insure for whatever you feel is fair value (let's just say $250k in this instance) and full replacement will cost $400k.  

If the house completely burns down, under fair market value approach the tax consequences are pretty easily determined by taking difference in payout vs the cost basis as the gain. However I'm wondering under full replacement cost, how this works out. Let's say the house was fully rebuilt for $400k. Under this scenario am I:

1) taxed for the excess $200k ($400k - cost basis) as capital gain and my cost basis is now $400k.

2) taxed for the excess $200k ($400k - cost basis) as capital gain and my cost basis remains as $200k.

3) not taxed for capital gain and my cost basis remains at $200k.

if it's either 1 or 2 I would almost steer away from full replacement cost since that would mean I am paying for a phantom gain that I will never realize (I would assume the fmv will most likely still be around $250k even if it was fully rebuilt with $400k of cost/labor).  Thank you in advance for your help! 

[Bill B.]

as a “layman” I can’t see anyway you are taxed s too many people have had properties they paid $50k for 30 years ago burn down in California. They will not be taxed on the $1M replacement. I would ASSUME the old cost basis remains and the insurance payment remains untaxed as long as it’s all spent on repairs. 

Imagine you have insurance and the $20k roof is destroyed by a tree. You don’t get to write off the $20k expense because you didn’t pay it, the insurance company did. You don’t get taxed on the insurance payment because it’s not income or a gain. But you also don’t get to add to your costs basis because you didn’t add to it. 

I can see getting taxed if you kept the money and didn’t rebuild, that would be closer to a sale?

Now I too an interested to hear from one of the many expert CPAs on BP.