Consequences of Damages Received
For Casualty Loss of Principal Residence
I. Facts: Attorney has filed a lawsuit on behalf of Client, claiming damages to Clients principal residence caused by a landslide created by a downhill neighbor. For purposes of this memo, it is assumed the fair market value of Clients property before damage was $950,000, Clients cost basis (including out-of-pocket repairs subsequent to the landslide) is $650,000 and the property is subject to a first deed of trust for $300,000. Client took a casualty loss of $70,000 on his 1998 tax return, therefore, his adjusted basis in his property is $580,000.
II. Issue: What are the tax consequences flowing from the following options:
1. Client sells or transfers the property to the insurance company representing the defendants for $1,000,000 or $1,200,000 and acquires a replacement residence within 2 years;
2. The same as 1 above, except that Client does not replace the principal residence within 2 years;
3. Client retains ownership of the property and receives payment for a casualty loss on the property;
4. Client retains ownership of the property and receives general damages for his loss; or
5. Client sells the property and leases it back from the insurance company for a period of 5 years.
Note:The following tax calculations are approximate and are useful for comparison purposes only. The actual tax consequences will depend on Clients total tax situation, including other income and deductions.
1. Client pays no tax on the replacement of his residence within the period ending two years after the close of the taxable year in which the gain is realized (replacement period). For example, if Client receives $1,000,000 on July 1, 1999, he has until December 31, 2001 to replace the residence. He is entitled to exclude $250,000 in profits; consequently, if he receives $1,000,000 in settlement, to eliminate taxes he must replace his principal residence within the replacement period at a cost of at least $750,000.
2. The same as 1, except that Client will pay capital
gains on profits in excess of $250,000. If he
receives $1,000,000, hell pay tax on $170,000 ($1,000,000 less $250,000 = $750,000
less $580,000 basis = $170,000) at a combined federal and California tax rate of
approximately 27.5%, or $47,750. If the sale
is $1,200,000, then the gain would be $370,000 and the tax at 27.5% would be $101,750. After payment of taxes and the mortgage, Client
will net $652,250 on $1,000,000 ($798,250 on $1,200,000) of settlement proceeds.
2. The same as 1, except that Client will pay capital gains on profits in excess of $250,000. If he receives $1,000,000, hell pay tax on $170,000 ($1,000,000 less $250,000 = $750,000 less $580,000 basis = $170,000) at a combined federal and California tax rate of approximately 27.5%, or $47,750. If the sale is $1,200,000, then the gain would be $370,000 and the tax at 27.5% would be $101,750. After payment of taxes and the mortgage, Client will net $652,250 on $1,000,000 ($798,250 on $1,200,000) of settlement proceeds.
3. If Client remains in the property and receives $1,000,000 as a casualty loss, the results should be the same as 2 above, except he would not be entitled to the $250,000 exemption because he did not sell the property. $1,000,000 in casualty loss payments should be taxed as follows: $1,000,000 less $580,000 basis = $420,000 in gain; $420,000 gain x 27.5% tax rate = $115,500 tax.
Note: The basis of property damaged by a casualty is reduced by the amount of insurance or other compensation received.
4. If Client remains in the home and receives general damages, then the entire amount will be taxed to him as ordinary income. If he receives $1,000,000 for emotional distress or related damages, then his combined federal and state tax bracket would be approximately 45%. $1,000,000 x 45% tax rate = $450,000 in taxes.
5. If Client sells the property and leases it back
for 5 years, the same as #2 above, except he will be making non-deductible lease payments. He may want to bargain for reduced lease payments
(or no lease payments) in the settlement process.
5. If Client sells the property and leases it back for 5 years, the same as #2 above, except he will be making non-deductible lease payments. He may want to bargain for reduced lease payments (or no lease payments) in the settlement process.
1. Client has a choice of either using the involuntary conversion rules under IRC Sec. 1033 to shelter the settlement proceeds from taxation by acquiring another principal residence within the replacement period or selling the property, using his $250,000 exclusion and paying tax on the balance.
2. To eliminate tax, Client needs $1.38 in additional settlement proceeds to reduce his taxes by $1.00. For example, if he receives $1,000,000 as the sale of his home, his tax will be $47,750. To eliminate this tax, Client needs an additional $65,895 in settlement ($65,895 x 27.5% tax rate = $18,121.13; $65,895.00 - $18,121.13 = $47,773.87).
3. As part of the settlement negotiations, Client could receive damages for the destruction of the building, retain the land, then make a charitable donation of the land. The sale of land is considered part of an integrated Sec. 1033 transaction, but I could not find a case dealing with a donation of land. The donation of land should not interfere with the residence exclusion, but I would need to thoroughly research this issue.
4. The wording of the settlement agreement should be consistent with the IRC section that is applicable, and the statement agreement should recite facts that are consistent with the tax treatment.CCa
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|All contents copyright © 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.|