Publication 225

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Do not report a gain if you receive reimbursement in the form of property similar or related in service or use to the destroyed, stolen, or other involuntarily converted property. Your basis in the new property is generally the same as your adjusted basis in the property it replaces.

You must ordinarily report the gain on your stolen, destroyed, or other involuntarily converted property if you receive money or unlike property as reimbursement. However, you can choose to postpone reporting the gain if you purchase replacement property similar or related in service or use to your destroyed, stolen, or other involuntarily converted property within a specific replacement period.

If you have a gain on damaged property, you can postpone reporting the gain if you spend the reimbursement to restore the property.

To postpone reporting all the gain, the cost of your replacement property must be at least as much as the reimbursement you receive. If the cost of the replacement property is less than the reimbursement, you must include the gain in your income up to the amount of the unspent reimbursement.

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Example 1.(p69)

In 1985, you constructed a barn to store farm equipment at a cost of $20,000. In 1987, you added a silo to the barn at a cost of $15,000 to store grain. In May of this year, the property was worth $100,000. In June the barn and silo were destroyed by a tornado. At the time of the tornado, you had an adjusted basis of $0 in the property. You received $85,000 from the insurance company. You had a gain of $85,000 ($85,000 – $0).

You spent $80,000 to rebuild the barn and silo. Since this is less than the insurance proceeds received, you must include $5,000 ($85,000 – $80,000) in your income.

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Example 2.(p69)

In 1970, you bought a cabin in the mountains for your personal use at a cost of $18,000. You made no further improvements or additions to it. When a storm destroyed the cabin this January, the cabin was worth $250,000. You received $146,000 from the insurance company in March. You had a gain of $128,000 ($146,000 − $18,000).

You spent $144,000 to rebuild the cabin. Since this is less than the insurance proceeds received, you must include $2,000 ($146,000 − $144,000) in your income.

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You cannot postpone reporting a gain from a casualty, theft, or other involuntary conversion if you buy the replacement property from a related person (discussed later). This rule applies to the following taxpayers.

C corporations.
Partnerships in which more than 50% of the capital or profits interest is owned by C corporations.
Individuals, partnerships (other than those in (2) above), and S corporations if the total realized gain for the tax year on all involuntarily converted properties on which there are realized gains is more than $100,000.

For involuntary conversions described in (3) above, gains cannot be offset by any losses when determining whether the total gain is more than $100,000. If the property is owned by a partnership, the $100,000 limit applies to the partnership and each partner. If the property is owned by an S corporation, the $100,000 limit applies to the S corporation and each shareholder.

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This rule does not apply if the related person acquired the property from an unrelated person within the period of time allowed for replacing the involuntarily converted property.

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Under this rule, related persons include, for example, a parent and child, a brother and sister, a corporation and an individual who owns more than 50% of its outstanding stock, and two partnerships in which the same C corporations own more than 50% of the capital or profits interests. For more information on related persons, see Nondeductible Loss under Sales and Exchanges Between Related Persons in chapter 2 of Publication 544.

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If a taxpayer dies after having a gain, but before buying replacement property, the gain must be reported for the year in which the decedent realized the gain. The executor of the estate or the person succeeding to the funds from the involuntary conversion cannot postpone reporting the gain by buying replacement property.

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Replacement Property

You must buy replacement property for the specific purpose of replacing your property. Your replacement property must be similar or related in service or use to the property it replaces. You do not have to use the same funds you receive as reimbursement for your old property to acquire the replacement property. If you spend the money you receive for other purposes, and borrow money to buy replacement property, you can still choose to postpone reporting the gain if you meet the other requirements. Property you acquire by gift or inheritance does not qualify as replacement property.

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If you are an owner-user, similar or related in service or use means that replacement property must function in the same way as the property it replaces. Examples of property that functions in the same way as the property it replaces are a home that replaces another home, a dairy cow that replaces another dairy cow, and farm land that replaces other farm land. A passenger automobile that replaces a tractor does not qualify. Neither does a breeding or draft animal that replaces a dairy cow.

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If, because of soil or other environmental contamination, it is not practical for you to reinvest your insurance money from destroyed livestock in property similar or related in service or use to the livestock, you can treat other property (including real property) used for farming purposes, as property similar or related in service or use to the destroyed livestock.

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If you sell or exchange livestock because of weather-related conditions (discussed earlier under Livestock Losses) and it is not practical for you to reinvest the sales proceeds in property similar or related in service or use to the livestock, you can treat other property (excluding real property) used for farming purposes, as property similar or related in service or use to the livestock you sold.

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Example.(p69)

Each year you normally sell 25 cows from your beef herd. However, this year you had to sell 50 cows. This is because a severe drought significantly reduced the amount of hay and pasture yield needed to feed your herd for the rest of the year. Because it is not practical for you to use the proceeds from selling the extra cows to buy new cows, you can treat other property (excluding real property) used for farming purposes, as property similar or related in service or use to the cows you sold.

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If a storm or other casualty destroyed your standing crop and you use the insurance money to acquire either another standing crop or a harvested crop, this purchase qualifies as replacement property. The costs of planting and raising a new crop qualify as replacement costs for the destroyed crop only if you use the crop method of accounting (discussed in chapter 2). In that case, the costs of bringing the new crop to the same level of maturity as the destroyed crop qualify as replacement costs to the extent they are incurred during the replacement period.

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Standing timber you bought with the proceeds from the sale of timber downed as a result of a casualty, such as high winds, earthquakes, or volcanic eruptions, qualifies as replacement property. If you bought the standing timber within the replacement period, you can postpone reporting the gain.

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If your destroyed business or income-producing property was located in a federally declared disaster area, any tangible replacement property you acquire for use in any business is treated as similar or related in service or use to the destroyed property. For more information, see Disaster Area Losses in Publication 547.

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Once you have acquired qualified replacement property that you designate as replacement property in a statement attached to your tax return, you cannot substitute other qualified replacement property. This is true even if you acquire the other property within the replacement period. However, if you discover that the original replacement property was not qualified replacement property, you can, within the replacement period, substitute the new qualified replacement property.

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You must reduce the basis of your replacement property (its cost) by the amount of postponed gain. In this way, tax on the gain is postponed until you dispose of the replacement property.

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To postpone reporting your gain, you must buy replacement property within a specified period of time. This is the replacement period.

The replacement period begins on the date your property was damaged, destroyed, stolen, sold, or exchanged. The replacement period generally ends 2 years after the close of the first tax year in which you realize any part of your gain from the involuntary conversion.

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Example.(p70)

You are a calendar year taxpayer. While you were on vacation, farm equipment that cost $2,200 was stolen from your farm. You discovered the theft when you returned to your farm on November 11, 2011. Your insurance company investigated the theft and did not settle your claim until January 5, 2012, when they paid you $3,000. You first realized a gain from the reimbursement for the theft during 2012, so you have until December 31, 2014, to replace the property.

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For your main home (or its contents) located in a federally declared disaster area, the replacement period ends 4 years after the close of the first tax year in which you realize any part of your gain from the involuntary conversion. See Disaster Area Losses, later.

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For property located in the Midwestern disaster areas (defined in Table 4 in the 2008 Publication 547) that was destroyed, damaged, stolen, or condemned, the replacement period ends 5 years after the close of the first tax year in which any part of your gain is realized. This 5-year replacement period applies only if substantially all of the use of the replacement property is in the Midwestern disaster areas.

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For property located in the Kansas disaster area that was destroyed, damaged, stolen, or condemned after May 3, 2007, as a result of the Kansas storms and tornadoes, the replacement period ends 5 years after the close of the first tax year in which any part of your gain is realized. This 5-year replacement period applies only if substantially all of the use of the replacement property is in the Kansas disaster area.

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For property located in the Hurricane Katrina disaster area that was destroyed, damaged, stolen, or condemned after August 24, 2005, as a result of Hurricane Katrina, the replacement period ends 5 years after the close of the first tax year in which any part of your gain is realized. This 5-year replacement period applies only if substantially all of the use of the replacement property is in the Hurricane Katrina disaster area.

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For the sale or exchange of livestock due to drought, flood, or other weather-related conditions in an area eligible for federal assistance, the replacement period ends 4 years after the close of the first tax year in which you realize any part of your gain from the sale or exchange. The IRS may extend the replacement period on a regional basis if the weather-related conditions continue for longer than 3 years.

For information on extensions of the replacement period because of persistent drought, see Notice 2006-82, 2006-39 I.R.B. 529, available at
www.irs.gov/irb/2006-39_IRB/ar11.html. For a list of counties for which exceptional, extreme, or severe drought was reported during the 12 months ending August 31, 2012, see Notice 2012-62, which is on page 489 of Internal Revenue Bulletin 2012-42 at
www.irs.gov/pub/irs-irbs/irb12-42.pdf.

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The replacement period for a condemnation begins on the earlier of the following dates.

The date on which you disposed of the condemned property.
The date on which the threat of condemnation began.

The replacement period generally ends 2 years after the close of the first tax year in which any part of the gain on the condemnation is realized. But see Main home in disaster area, Property in the Midwestern disaster areas, Property in the Kansas disaster area, and Property in the Hurricane Katrina disaster area, earlier, for exceptions.

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If real property held for use in a trade or business or for investment (not including property held primarily for sale) is condemned, the replacement period ends 3 years after the close of the first tax year in which any part of the gain on the condemnation is realized.

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You can apply for an extension of the replacement period. Send your written application to the Internal Revenue Service Center where you file your tax return. See your tax return instructions for the address. Include all the details about your need for an extension. Make your application before the end of the replacement period. However, you can file an application within a reasonable time after the replacement period ends if you can show a good reason for the delay. You will get an extension of the replacement period if you can show reasonable cause for not making the replacement within the regular period.

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Sale of Property, Gain or Loss

You postpone reporting your gain by reporting your choice on your tax return for the year you have the gain. You have the gain in the year you receive insurance proceeds or other reimbursements that result in a gain.

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You should attach a statement to your return for the year you have the gain. This statement should include all the following information.

The date and details of the casualty, theft, or other involuntary conversion.
The insurance or other reimbursement you received.
How you figured the gain.

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If you acquire replacement property before you file your return for the year you have the gain, your statement should also include detailed information about all the following items.

The replacement property.
The postponed gain.
The basis adjustment that reflects the postponed gain.
Any gain you are reporting as income.

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If you intend to buy replacement property after you file your return for the year you realize gain, your statement should also say that you are choosing to replace the property within the required replacement period.

You should then attach another statement to your return for the year in which you buy the replacement property. This statement should contain detailed information on the replacement property. If you acquire part of your replacement property in one year and part in another year, you must attach a statement to each year's return. Include in the statement detailed information on the replacement property bought in that year.

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If you choose to postpone reporting the gain on weather-related sales or exchanges of livestock, show all the following information on a statement attached to your return for the tax year in which you first realize any of the gain.

Evidence of the weather-related conditions that forced the sale or exchange of the livestock.
The gain realized on the sale or exchange.
The number and kind of livestock sold or exchanged.
The number of livestock of each kind you would have sold or exchanged under your usual business practice.

Show all the following information and the preceding information on the return for the year in which you replace the livestock.

The dates you bought the replacement property.
The cost of the replacement property.
Description of the replacement property (for example, the number and kind of the replacement livestock).

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You must file an amended return (Form 1040X) for the tax year of the gain in either of the following situations.

You do not acquire replacement property within the replacement period, plus extensions. On this amended return, you must report the gain and pay any additional tax due.
You acquire replacement property within the required replacement period, plus extensions, but at a cost less than the amount you receive from the casualty, theft, or other involuntary conversion. On this amended return, you must report the part of the gain that cannot be postponed and pay any additional tax due.

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Postponing Gain(p68)

Example 1.(p69)

Example 2.(p69)

Buying replacement property from a related person.(p69)

Death of a taxpayer.(p69)

Replacement Property(p69)

Owner-user.(p69)

Soil or other environmental contamination.(p69)

Weather-related sales of livestock.(p69)

Example.(p69)

Standing crop destroyed by casualty.(p69)

Timber loss.(p69)

Business or income-producing property located in a federally declared disaster area.(p69)

Substituting replacement property.(p69)

Basis of replacement property.(p69)

Replacement Period(p70)

Example.(p70)

Main home in disaster area.(p70)

Property in the Midwestern disaster areas. (p70)

Property in the Kansas disaster area.(p70)

Property in the Hurricane Katrina disaster area.(p70)

Weather-related sales of livestock in an area eligible for federal assistance.(p70)

Condemnation.(p70)

Extension.(p70)

How To Postpone Gain(p70)

Required statement.(p70)

Amended return.(p70)