Tax Treatment for Involuntary Conversions

In our first post in this series, we defined an involuntary conversion as a mandatory liquidation of assets, such as a loss due to destruction, theft, condemnation, or repossession. In most instances, the lost property is replaced by another asset such as cash or insurance proceeds.

Under both generally accepted accounting principles (GAAP) and tax regulations, the difference between the net book value of the assets destroyed and the cash or insurance received is recognized as a gain or a loss. While taxpayers may not mind recognizing a casualty loss, insurance proceeds often exceed the tax net book value of the assets destroyed, resulting in a potential casualty gain.

In good news for taxpayers, the tax on casualty gains may be eligible for deferral under special involuntary conversion rules. Eligible casualty gains can be deferred until the tax year in which the property purchased to replace the destroyed assets is disposed of in a taxable transaction.

To qualify for deferral:
  • The destroyed assets must be replaced within two years after the close of the tax year in which the involuntary conversion occurs.
  • A statement must be attached to the return for the year in which the involuntary conversion occurred setting forth the election to defer the gain.
  • The cost of the replacement assets must be reduced by the amount of the deferred gain. Generally, this will result in replacement assets receiving a carry-over basis equal to the tax net book value of the destroyed assets.
Notes:
  • If you spend less than the amount of insurance proceeds received, gain is recognized (equal to the amount of insurance proceeds not spent).
  • If you spend more than the amount of insurance proceeds received, no gain is recognized. While the basis of the assets purchased with the insurance proceeds is limited to carry-over basis, the basis of assets acquired with excess funds equal replacement cost.
Let’s apply these tax rules to the example used in our previous blog post on accounting treatment for involuntary conversions. In that example, a restaurant was destroyed due to fire damage in 2015 with an asset cost of $500,000 and accumulated depreciation of $250,000 (tax net book value is the difference between these, or $250,000). Insurance proceeds received were $300,000, and the cost to rebuild the restaurant was assumed to be $375,000.

The amount of the potential tax gain is the same as GAAP, or $50,000. This is the difference between the insurance proceeds ($300,000) and the tax net book value of the destroyed assets ($250,000).

Assuming a valid election to defer the gain is made, and the assets are replaced within the requisite two years, the $50,000 tax gain can be deferred until the replacement assets are subsequently disposed.

The cost of the replacement assets are $325,000, which is the fair market value of the new assets ($375,000) less the amount of the gain deferred ($50,000). Put another way, the cost of the replacement assets equals the carry-over basis of the destroyed assets ($250,000) plus the amount of cash spent above the insurance proceeds ($75,000).

Situations involving involuntary conversions can be difficult – emotionally and financially.

This post previously ran on the Selections Blog on August 6, 2013.

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