When your business property is destroyed, damaged, or stolen, you may receive an insurance recovery, grants, or some other compensation (such as amounts paid by BP for losses in the Deepwater Horizon oil spill that occurred in the Gulf of Mexico in 2010). This recovery can produce a tax gain because it exceeds the tax basis in the property even though you’ve suffered an economic loss.
How can this be? This is because you may have little or no tax basis in the property, so the recovery produces a gain. Tax basis usually is your cost for the asset, but this is reduced by any depreciation claimed. Thus, your basis in an asset the cost of which has been written off with first-year (Sec. 179) expensing or bonus depreciation is zero, causing all of the insurance recovery to be treated as a tax gain.
Postponing gain. The good news is that you don’t have to pay tax on the gain now. You can opt to postpone the gain by acquiring qualified replacement property within a set time limit:
- The replacement period for business property is usually two years (three years for real property that’s been condemned; four years for losses to personal or real property in disaster areas). The period runs to the end of the year in which gain is realized from the destruction, damage, or theft (collectively these are referred to in tax law as involuntary conversions). It may be five years in special situations (e.g., losses during Midwestern disaster area in 2008). You may be able to obtain an extension of up to one year if you request it and have a good reason why you didn’t obtain replacement property within the usual replacement period.
- Qualified replacement property is property similar or related in service or use. This means the replacement property has a close “functional” similarity to the converted property.
Gain doesn’t become tax free; it’s merely postponed. This is because the basis in the new property is the same as the basis in the converted property. Gain ultimately will be recognized when the replacement property is sold or disposed of in a taxable transaction later on.
Let’s put these rules together in an example.
In 2013 a machine that cost your business $60,000 is completely destroyed in a flood. You had acquired the machine in 2011 and written it off using the 100% bonus depreciation option that applied that year. Insurance pays you $50,000 this year for your loss. Technically, all of this recovery is taxable gain. However, you can postpone reporting the gain by buying a replacement machine before the end of 2017. The basis of the new property is what it cost you minus the gain that you didn’t recognize ($50,000). So if you buy a new machine for $70,000, its basis becomes $20,000 ($70,000 - $50,000).
When it comes to gain on livestock sales that were forced to occur because of severe drought, the IRS has the authority to grant farmers and ranchers an extra year to obtain replacements for the livestock, which it did recently. This relief applies to sales of livestock held for draft, dairy, or breeding purposes that were sold due to drought.
Relief applies only to farmers and ranchers located within drought areas eligible for federal assistance. A list of these counties, cities, parishes, and boroughs are in the appendix to Notice 2013-62. However, sales of other livestock, such as those raised for slaughter or held for sporting purposes, and poultry, are not eligible for this extended relief.
Special rules for inventory. Generally, the deferral rule doesn’t apply to inventory (technically referred to as stock in trade held for sale to customers). However, inventory destroyed in a federally-declared disaster is eligible for the replacement rule applied to involuntary conversions.
Find more details about the tax treatment of gains on involuntary conversions in IRS Publication 547. However, if you have experienced an involuntary conversion, work with your tax advisor to determine the best course of action for your situation.