Theoretically, our beloved Internal Revenue Code allows you to claim an itemized deduction — on Schedule A of your Form 1040 — for personal casualty losses to the extent they are not covered by insurance. Exactly what is a casualty loss? It’s when the fair market value of your property or asset is reduced or wiped out by a hurricane, flood, storm, fire, earthquake or volcanic eruption (not to mention sonic boom, theft or vandalism).OK, so you don't get a tax break, but above I said it could cause you to have a tax payment; how does that work?
In reality, however, many disaster victims won’t qualify for any personal casualty loss write-offs because of the following two rules. First, you must reduce your loss by $100. Obviously, that’s no big deal. Then you must further reduce the loss by an amount equal to 10% of your adjusted gross income (AGI) for the year (AGI is the number at the bottom of page 1 of your Form 1040). That is a big deal. Say you incur a $20,000 personal casualty loss this year and have AGI of $100,000. Your write-off is a relatively puny $9,900 ($20,000 minus $100 minus $10,000). You get absolutely no tax break if your loss before the two required subtractions is $10,100 or less, and you have no chance at all if you don’t itemize.
When you have insurance coverage for disaster-related property damage — under a homeowners, renters, or business policy — you might actually have a taxable gain instead of a deductible casualty loss. Why? Because if the insurance proceeds exceed the tax basis of the damaged or destroyed property (normally equal to its cost), you have a taxable profit as far as the IRS is concerned. This is the case even if the insurance company doesn’t fully compensate you for the pre-casualty value of the property. These gains are called involuntary conversion gains — because the casualty event causes your property to suddenly be converted into cash from the insurance proceeds.Nice, you get to rebuild your house, and send some money to the IRS for your trouble. At least they let you stretch it out; it's not worth confiscating your house until it's been restored.
For example, you could have a big involuntary conversion gain if your valuable vacation home is heavily damaged or destroyed and your insurance coverage greatly exceeds what you paid for the property when you bought it years ago.
If you have an involuntary conversion gain, it generally must be reported as income on your Form 1040 unless you (1) make sufficient expenditures to repair or replace the property and (2) make a special tax election to defer the gain. If you make the election (you generally should), you have a taxable gain only to the extent the insurance proceeds exceed what you spend to repair or replace the property. The expenditures for repairs or replacement generally must occur within the period beginning on the date the property was damaged or destroyed and ending two years after the close of the tax year in which you have the involuntary conversion gain.