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Flood relief.

In July 1993 the overflowing Mississippi River destroyed the principal residence of Joe Homeowner. Until the residence is rebuilt and ready for occupancy in August 1995, Joe and his family will have to live somewhere else.

Fortunately, Joe's insurance contract provides for a temporary increase in living expenses in the event of the loss of his principal residence due to fire, storm or a similar casualty. Are the insurance proceeds taxable?

Section 61 of the Internal Revenue Code says gross income includes all income from any source except as otherwise provided by law. However, IRC section 123(a) says if an individual's principal residence is damaged or destroyed by fire, storm or a similar casualty, amounts received by the individual under an insurance contract are not included in gross income if paid to compensate or reimburse for living expenses incurred by the taxpayer and members of his or her household resulting from the loss of the residence's use or occupancy.

Section 123(b) limits this exclusion to the excess of the actual living expenses incurred over normal living expenses that would have been incurred during the period. Generally, such additional expenses include the extra costs of renting suitable housing and any extraordinary expenses for transportation, food, utilities and other services. Thus, the taxpayer and his or her family can maintain their customary standard of living during the loss period.

But what if the insurance proceeds exceed the individual's increased living expenses during the loss period? According to revenue ruling 93-43, if that is the case, the excess portion of the insurance money is included in the individual's gross income for the taxable year in which the loss period ends or, if later, for the taxable year in which the excess portion of the insurance proceeds is received.

For example, Joe received a total of $25,000 in insurance proceeds for increased living expenses ($20,000 in 1993, $3,000 in 1995 and 2,000 in 1996) while he incurred a total of $22,000 in increased living expenses ($5,000 in 1993, $10,000 in 1994 and $7,000 in 1995). The $20,000 in insurance proceeds Joe received in 1993 plus the $3,000 received in 1995 exceed by $1,000 the increased living expenses of $22,000 incurred during the loss period (1993-95). Therefore, in accordance with revenue ruling 93-43 $1,000 of the insurance money must be included in Joe's gross income in 1995, the taxable year in which the loss period ended. The remaining $22,000 is excluded.

The $2,000 in insurance proceeds received in 1996 will be included in Joe's 1996 gross income, the taxable year in which this excess portion was received.

Observation: The section 123 exclusion does not apply to an insurance recovery for lost rental income. It also does not apply to an insurance recovery that compensates for lost or damaged real or personal property. Such situations may qualify as casualty losses under tax code section 165(c)(3) or involuntary conversions under section 1033.

Finally, the section 123 exclusion does apply in the case of individuals denied access to a principal residence by government authorities because of a disaster (or the threat of a disaster).
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Title Annotation:taxation of insurance proceeds
Publication:Journal of Accountancy
Date:Oct 1, 1993
Previous Article:Power to invade principal meant trust fund was includable in estate.
Next Article:Averaging can't be used when participant died before age 59 1/2.

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