IRS follows AICPA position in guidance on proceeds received for homes and contents destroyed by disasters.

Taxpayers in presidentially declared disaster areas received good news from the IRS in March. In Rev. Rul. 95-22, the IRS adopted a position allowing gain to be deferred if the insurance proceeds for a home and its contents are reinvested in a replacement residence and/or any type of replacement property.

Previously, the IRS Western Region Counsel, under guidance from the IRS National Office, had taken the position that to avoid gain recognition, the common pool of funds (received for the residence and scheduled contents) had to be reinvested only in property similar or related in service or use to the residence or the scheduled property. The AICPA, in the Tax Division's 1994 edition of the Disaster Area Practice Guide, disagreed with this earlier IRS position. The AICPA is pleased with the Service's new position, as it follows the statutory intent of Sec. 1033(h), which was enacted by the Omnibus Budget Reconciliation Act of 1993 (OBRA).

According to Rev. Rul. 95-22, the tax treatment of insurance proceeds received for residences and contents destroyed by disasters, and the use of such proceeds, is:

* No gain is recognized on insurance proceeds - received for unscheduled (general) personal property, regardless of how the proceeds are used. * Proceeds received for the residence and scheduled personal property (i.e., that property itemized for insurance purposes) are treated as a common pool of funds. * No gain is recognized to the extent that the common pool of funds is reinvested in property similar or related in service or use to the original residence or its contents, regardless of whether or not the replacement contents are scheduled.

Rev. Rul. 95-22 permits taxpayers who suffer from the devastating consequences of a disaster loss to replace the necessities of life (including such unscheduled necessities as furniture, appliances and linens) without tax consequence, before replacing luxury items of the type that are typically scheduled (such as jewelry and artwork). The new ruling recognizes that these individuals, who by all standards and measurements endure incredible hardship and loss for which they are never adequately compensated, will now not be penalized for such decisions.

The AICPA Individual Taxation Committee has been working on this issue for quite a while. Initially in response to a letter from an AICPA member involved in a California Society of CPAs group dealing with the tax ramifications of the horrors of the Oakland firestorms, David Lifson, chair of the Individual Taxation Committee, set up a working group to address the tax issues involved with disasters. The working group decided that, due to the many natural disasters that occurred in the early 1990s (e.g., the Oakland firestorms, Hurricane Andrew and Hurricane Iniki) and the lack of comprehensive guidance for practitioners in this area, it would develop an AICPA Disaster Area Practice Guide. The guide, issued in January 1993, includes references to certain aspects of related events, the tax treatment of which is similar to that provided for natural disasters. The guide is designed to be used as an educational and reference source for AICPA Tax Division members and others interested in the subject. (Incidentally, the AICPA Disaster Area Practice Guide received the Award of Excellence from the American Society of Association Executives (ASAE).)

Specifically, the Disaster Area Practice Guide covers the following issues:

* Personal casualty losses (the amount of the loss, deduction limits and leased property issues, etc.). * Disaster losses. * Taxable income (consideration of involuntary conversions when there is and is not a presidentially declared disaster, and living expenses). * Business or income-producing property (business versus nonbusiness real property, business interruption insurance, proof of loss and tax planning). * Problems and solutions. * IRS reference materials. * Statements to accompany tax returns. * Checklist for dealing with natural disasters. * The Florida Institute of CPAs' questions to, and responses from, the IRS regarding the tax ramifications of a disaster.

During 1993, when Congress was considering legislation granting relief to victims of natural disasters (especially for the Mississippi River flood), the AICPA strongly supported the legislation and sent letters to Congress favoring the modification of the involuntary conversion rules for disaster-related conversions - Sec. 1033(h), on which Rev. Rul. 95-22 was based. The AICPA stated that the proposed modification to Sec. 1033 accomplished a great deal in terms of simplification and fairness. The Institute even advocated that the concept embodied in the legislation should not be limited to victims of a disaster, but should be applied to all taxpayers who suffer a casualty loss. Congress did not adopt the broader approach, but did provide relief to taxpayers suffering from presidentially declared disasters.

The prior law required the application of the involuntary conversion rules to each individual item of personal and real property. However, Sec. 1033(h) removed unscheduled property from those onerous rules. It assisted taxpayers who, under normal circumstances, rarely (if ever) keep adequate records of the original cost of most items in their homes, and who would likely be unable to determine if the sale of household contents was for a gain or loss. The provision took into account the fact that when a home is totally destroyed, even those records that did exist are probably lost, and it is impossible to determine whether a gain was realized or not. Furthermore, insurance proceeds often do not begin to cover the original cost or true replacement value of items lost, or come close to replacing the sentimental value of family heirlooms. Exempting the proceeds for contents while allowing the common pool of funds to be spent on the house and contents ensures that disaster victims are not taxed on phantom gain, and that victims are not penalized for the choices they make as they rebuild and recover from the devastation.

This legislation was proposed to accord homeowners the same relief under Sec. 1033 that business owners are granted. In Massillon Cleveland Akron Sign Co., 15 TC 79 (1950) (to which the IRS acquiesced), a business was allowed to treat insurance proceeds received for business personal and real property as fungible proceeds; as long as the proceeds were spent on items similar or related in service or use, the court held that no gain was recognized. Another intent of this provision was to overrule the Service's position in Letter Ruling 8127089, which held that artwork in one medium (lithograph) was not similar or related in service or use to artwork in another medium (watercolors). Congress intended that disaster victims be able to replace their particular home and contents as they desired, as long as the proceeds are reinvested in contents similar or related in service or use to the individual's home and contents prior to the disaster.

Reading the legislation without considering this intent (as the IRS previously had done in its Western Region Counsel position) would have placed an unreasonable burden on disaster victims, forcing them to pay taxes on insurance proceeds if the proceeds were spent in a different allocation to classes or items of property than that for which received, or if these victims chose to furnish their homes in a manner different from before the disaster. Since it is clear that relief was the primary goal for this provision, the AICPA believed that Sec. 1033(h) should be read liberally - to benefit these taxpayers, not to restrict them.

To take into account these changes made by OBRA, in July, the AICPA Individual Taxation Committee updated the Disaster Area Practice Guide. And again, in March 1995, the AICPA Individual Taxation Committee Disaster Area Working Group updated the Disaster Area Practice Guide, via an addendum, to cover a few more issues, as well as the Service's new position. The addendum addresses the timing of revoking the election to claim a disaster loss deduction for the preceding year, as well as the tax treatment of casualty losses in excess of income for purposes of computing net operating losses (NOLs) and the alternative minimum tax (AMT) implications. Specifically, in addition to the tax treatment provided in Rev. Rul. 95-22 on involuntary conversions of home and contents destroyed in disasters, the addendum states that:

* Since the Tax Court has held (and the IRS acquiesced) that Regs. Sec. 1.165-11 (e) is invalid as to its 90-day limitation on revoking the election to claim a disaster loss deduction in a preceding year, taxpayers have until the due date (excluding extensions) of the income tax return for the tax year in which the disaster occurred to revoke their election. * Casualty losses, whether related to business or nonbusiness property, are considered deductions attributable to a trade or business for purposes of computing the NOL deduction. * Casualty losses are deductible in computing AMT income. * Regular and AMT casualty loss deductions should be the same.

Copies of the updated Disaster Area Practice Guide were sent to all the state CPA societies. In fact, the California Society of CPAs received several copies for use in that state's flood area declared a disaster by President Clinton in early 1995. As natural disasters from earthquakes, floods, fires, hurricanes and tornadoes will inevitably continue to occur, the updated AICPA Disaster Area Practice Guide remains a valuable resource for taxpayers and practitioners.