Whether a hurricane has stolen your roof or a thief your television, a payout from your homeowners insurance can really dig you out of disaster. But should you be setting aside some of the money to pay federal income taxes? Generally, the proceeds of casualty insurance are not considered taxable income so you don't have to worry about the tax bill. The situation may be different if you profit from the insurance claim, however.
How Does Homeowners Insurance Work?
Homeowners insurance provides payment to cover your loss. Assuming you're covered for the peril such as a fire, theft or a windstorm, then you can expect to be reimbursed for the exact amount you lost. If you lost a laptop and a diamond ring, the insurance will pay for the laptop and diamond ring. If your kitchen was destroyed in a fire, the insurance settlement will pay for a new kitchen plus whatever repairs, plastering and decorating are needed to put the kitchen back to how it was before the fire happened. Making you financially whole again after an insurance event is known as the principle of indemnification.
You are not expected to profit from an insurance claim. In fact, claiming more than you lost – either by including items in the claim that were not actually damaged or by exaggerating the value of a damaged item – might constitute insurance fraud. Even a "soft" fraud like overstating the value of the damage caused is punishable by fines and jail time of up to one year.
Is an Insurance Settlement Taxable?
Since you're not profiting from the insurance payout, then you don't have any taxable income. As long as you receive the right amount of money to fix up the damage or replace items that were stolen, then you don't need to report the settlement to the Internal Revenue Service.
It's up to you how you spend the payout. For example, if you received a settlement for a stolen laptop, you don't have to buy another laptop. As far as the IRS is concerned, how you spend the money does not matter. What matters is that you received a check corresponding to the value of the laptop and made no profit from the transaction.
What Happens if You Profit From the Payout?
There's really only one situation where insurance compensation is taxable, and that's if the settlement exceeds the original cost of the damaged property. This is not as unusual as it sounds since the value of your home may have gone up considerably since you bought it. For example, you may have bought your home 20 years ago for $75,000 but it's now worth $200,000 and insured for that amount. If the house is raised to the ground by fire, your insurance coverage will greatly exceed the original cost of the property.
To determine whether you have an involuntary conversion gain – that's IRS jargon for a gain in excess of the original value of the property – you'll need to calculate the adjusted basis of whatever was damaged or stolen. With your home, for example, the basis is the purchase price plus the cost of major renovations. A $75,000 house with a $15,000 kitchen remodel has a cost basis of $90,000.
If the insurance company paid you $200,000, then you have a taxable profit of $110,000. You'll need to report this gain as income on your Form 1040 in the year you received the insurance money and pay taxes at your standard income tax rate.
Involuntary Conversion Exclusions
The Internal Revenue Code provides two taxpayer-friendly ways of reducing your tax liability in the event of an involuntary conversion gain. The first is the primary residence exemption. If your main home was damaged or destroyed, and you lived there for at least two of the five years prior to the insurance event, then you can exclude $250,000 in insurance gains ($500,000 if you file jointly). This rule is exactly the same as if you sold your primary residence.
If you bought your home 20 years ago with an adjusted basis of $90,000 but the insurer cut you a check for the home's fair market value of $200,000, thanks to the primary residence exemption, you have no tax liability despite the $110,000 gain.
The second option is something called a gain deferral election. If you use your insurance check to replace the damaged property with similar property, then you should be able to defer the involuntary conversion gain until you sell the new property. This rule is helpful when the payout relates to investment property, for example, and the primary residence exclusion doesn't apply.
The immediate effect of making a gain deferral election is that you reduce your taxable gain in the year you receive the insurance payout. Deferring the gain means you only pay tax on the amount of the insurance proceeds that exceed what you spend to replace the damaged item. The replacement must be apples-for-apples – you cannot defer the gain if you buy a factory after a three-bedroom townhome burns down. You also have to purchase the replacement within a strict time window, starting on the date of the casualty event and ending two years after the end of the tax year in which you received your insurance check.
What if You Receive a Lower Settlement Than Expected?
In many cases, the settlement you receive may be lower than the amount you spend to repair or replace the damaged item. When technology is damaged, for instance, the insurance compensation rarely exceeds the purchase price since computers, televisions and the like depreciate over time. That means there's no taxable gain, and there might even be an insurance loss.
In theory, IRS rules allow you to claim an itemized deduction for casualty losses that are not covered by insurance. In reality, you might not qualify for the deduction thanks to two little-known rules: First, you must subtract $100 from the loss amount, which is no big deal. Second, you must subtract an amount equal to 10 percent of your adjusted gross income from the casualty loss. The tax deduction applies to the sum that's left over.
Here's an example: Suppose you get a $30,000 insurance payout for a burglary at your home but the original cost of the stolen items was $40,000. That represents a $10,000 casualty loss. Your AGI is $100,000. Your deduction will be the $10,000 casualty loss minus $100 minus $10,000 (10 percent of your AGI), which results in a negative figure. You get no write-off for the loss in this situation.
If the hypothetical loss was $20,000, on the other hand, you could claim a deduction of $9,900 ($20,000 minus $100 minus $10,000).
Special Rules for Qualified Disasters
If you've been unfortunate and lost property in a federally declared disaster such as Hurricane Harvey, Irma, Maria or the California wildfires, then your casualty losses should enjoy a more favorable tax treatment. Basically, the $100 reduction increases to $500 but the 10 percent of your AGI limit does not apply. You can deduct the entire portion of your losses that are not covered by insurance that exceed $500.
You should claim qualified disaster losses on Form 4684, Casualties and Thefts. IRS Publication 976, Disaster Relief, has more information about the disasters that qualify and their coverage zones.