Insurance settlement taxable?

[Sam Rogers]

I have a friend that recently received an insurance settlement that far exceeds the cost to repair the damage from a small fire at one of their rental properties. They made the repairs and now are left with a hefty windfall.

I know that this is not the end all be all place for tax advice, however, has anyone encountered this before? I am concerned that they will have to pay taxes on the "gains" from the insurance settlement. 

[Michael Plaks]

@Sam Rogers

Buckle up, this is complicated. With a casualty loss, three separate tax events happen. Very important to realize that these 3 events are separate: you do not simply add them up together as you tried to do in your question.

1. Casualty loss. 

Think of that as loss of value. As if you did not have insurance and did not fix the damage but simply decided to sell the property. Before the fire you could sell it for $200k. After the fire you can only sell it for $150k. You have a $50k casualty loss, whether or not you actually sold the property.

This loss is always deductible, even if your regular rental losses are limited by so-called passive activity loss (PAL) rules that kick in when your income is too high.

The best way to establish the before and after numbers is from an insurance adjuster report. Without such report, you have other methods, but it's a different topic.

Important: casualty loss is reduced by insurance proceeds. If, in our example, the insurance paid you $40k after deductible, depreciation adjustment and whatnot, then your deductible loss is only $50k - $40k = $10k.

2. Basis reduction

Tax basis is what you initially paid for the property plus rehab (if any) minus depreciation taken. It can get quite complicated, but I will stop at this simplified definition. The main importance of tax basis is that it determines capital gains when you sell the property.

Example. You bought the property for $100k, including closing costs, then put $30k into initial rehab, then started renting it and claimed $25k of depreciation since then. Your basis is $100k + $30k - $25k = $105k. If you sell this property today for $150k, then you have a capital gain of $150k - $105k (basis) = $45k. 

Here is the most confusing part that trips even some CPAs, not to mention investors. When you have a casualty loss, you must reduce your basis by the entire drop of value, or $50k in our example. Notice that the reduction includes BOTH the deductible tax loss of $10k AND the $40k insurance reimbursement. This may sound wrong, but it is right.

The result of this mandatory (but often overlooked) adjustment is that you will have $50k more in capital gains when you sell the property. Fair? Yes! You got a $10k tax deduction without spending money on it, and plus you got $40k cash from insurance. You will pay taxes on this money eventually, which is at sale time.

The only time insurance can be taxable when received is if you received more insurance money than your basis. Then your basis is dropped to zero, and the overage is taxable income. Otherwise, the taxes on insurance proceeds wait until you sell the property, via basis reduction.

3. Repairs.

Very important: the first two tax events, casualty loss and basis reduction, have nothing to do with fixing the damage! They happen regardless of whether or not you do the repairs. Repairs are a completely separate tax event!

Now, whatever you need to spend to fix the damage is treated the usual way, just like any other work you do on your property. If it's minor and cosmetic, as in cleanup and repainting, it is deducted as repairs. If it is major, as in gutting the damaged area and rebuilding, it is capitalized and depreciated. Some capital items like a new carpet can be deducted immediately via bonus depreciation. Usually, it's a combination of deductible and depreciable items.

One more time: you do not deduct repairs from insurance proceeds! This calculation is natural from an investor's view, as it gives you "the free money" from insurance. But it is completely meaningless for tax purposes. And, by the way, this money is not free anyway, it will get taxed when you sell.