IRS Sets Donated-Property Traps
Q: I bought a time share in foreclosure for an amount that was many times less than identical units are currently selling for. I want to donate this time share to a charitable organization. What kind of tax deduction am I allowed to claim? Is it based on what I paid or the fair market value of similar units not sold at foreclosure? -- R.P.B .
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A: You are venturing, perhaps unknowingly, into some potentially treacherous waters. Be warned that this territory has been filled with IRS traps designed to ensnare those who would bottom-fish for distressed properties and later transform them into tax-deductible charitable contributions.
There are several tests you must meet for your strategy to work. For starters, you must hold your property for at least one year to claim a deduction higher than the amount you paid for that asset. If you wait this period, then you may value your donation based on what similar properties are selling for.
However, if the value of the donation is more than $5,000, you must secure an independent appraisal of the asset. The appraisal must be signed by the person performing it and filed with your tax return. (You must complete Form 8283 as well.) An independent appraisal is not necessary if the value of the donation is less than $5,000.
There’s more. If the charity disposes of the property you donate within two years of its receipt and receives more than $500 for it, the IRS must be notified of the price the charity received, along with the name of the donor. You should know that most charities dispose of gifts such as real estate, automobiles, time shares and the like rather quickly because they cost the charity money to maintain. And you should also know that any significant difference between the amount the charity receives for the asset and its appraisal can trigger an immediate IRS audit. Be careful.
IRS Casualty Insurance Proceeds Rules Cited
Q: In two recent columns you discussed the circumstances under which taxes could be levied on unreinvested casualty insurance settlement proceeds. Will you cite the actual IRS code section and explain its rationale? I can’t fathom why unspent homeowner casualty insurance proceeds should be potentially taxable. Why don’t the same rules apply as with auto insurance settlements that are not spent for car repair? -- H.J.F .
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A: The rules governing casualty insurance proceeds are covered in Sect. 165 of the Internal Revenue Code. Now for the “why” of these regulations.
Basically, the government does not want us to collect money without paying taxes on it, and they consider insurance proceeds a source of such funds. To understand why, you must first understand that unreinvested insurance proceeds are considered taxable only to the extent that they result in a gain for the taxpayer.
Consider this scenario: You receive a $50,000 insurance settlement that you choose not to spend to repair your home. Then you sell the home, on which you had a $100,000 taxable basis, for $300,000. You must add the $50,000 settlement proceeds to your $200,000 taxable gain because your tax basis in the house was reduced by the amount of the unspent settlement. Of course, you may defer payment of the tax by purchasing a home for equal or greater value.
Despite your belief to the contrary, this philosophy applies equally to auto insurance payments. However, because cars generally depreciate in value--unlike real estate which typically has appreciated--a sale of a used car rarely results in a gain.
For example, if you bought a car for $20,000 and received a $2,000 repair settlement that you did not spend on repairs, you would be liable for taxes on that amount if you received more than $18,000 when you sold the vehicle. But as you well know, unless the car is a vintage model--and in terrific condition--you are unlikely to see such a sales price.
By the way, if you really want to be angry at Uncle Sam’s taxation policy, you should focus on the fact that he taxes gains from residential home sales--but does not offer tax deductions for any losses suffered on the sale on your principal residence.
Homeowner Settlement Gain or Profit Exclusion
Q: Can you take a few more questions on casualty insurance reinvestments? If a home is sold within the four or so years allowed for reinvestments, is the unspent portion taxable? Can a homeowner apply his or her $125,000 profit exclusion to this amount if they are eligible to invoke it? -- R.E .
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A: If the home is sold before the settlement money is spent--and that sale results in a gain for the homeowner--the settlement proceeds are added to the taxable gain on the transaction. If a homeowner qualifies for the $125,000 profit exclusion, it can be applied against the entire gain, including the amount of the insurance settlement.
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Note: Due to an editing error, last week’s item on the taxability of casualty insurance settlements was misleading.
The answer addressed how taxes are assessed on homeowner insurance settlement proceeds that are not spent within approximately four years of receipt to repair the damage to the house.
Taxes are levied on unreinvested insurance proceeds to the extent that the settlement results in a gain to the taxpayer. How the gain is realized differs according to the circumstances of the taxpayer. If the unreinvested proceeds are greater than the taxpayer’s basis in the home, that excess is subject to taxation at the end of the four-year period.
If the unspent proceeds are less than the basis, they are not immediately taxable. However, the taxpayer’s basis in the home is reduced by the amount of the settlement--thus subjecting the taxpayer to taxation on a larger gain.
