A common issue among landowners, both large and small, is vandalism occurring on the property. One of the most interesting stories regarding vandalism is a Florida farm-owner we know woke up in the middle of the night in the ’80s to the cartel landing a plane full of cocaine on his property without permission. In doing so, the plane ran over his fence & caused a ton of damage to the property. When something like this happens, farmers are surprised to know of the potential tax consequences or benefits of this event.
A vandalism, theft, or destruction event usually results in a taxpayer filing a police report and an insurance claim. The insurance company then assesses the damage and the value of the property damaged or stolen and issues compensation to the farm owner. The first step in analyzing the taxation of insurance proceeds in a theft, vandalism, or destruction event, taxpayers must understand whether the property was business property or personal-use property.
When insurance funds are received for damaged or destroyed business property, they are treated differently than insurance funds a farmer receives when their crops are destroyed in a storm or from a disease. Insurance funds received for business property damage are taxable if the amount received exceeds the farmer’s basis in the property damaged and the farmer does not fully reinvest the proceeds in the replacement property. As a reminder form previous articles, the tax basis is the amount the taxpayer paid for the asset less the accumulated depreciation taken on the asset.
As an example, let’s assume a farmer purchases a tractor for $100,000 and the farm has taken $70,000 worth of depreciation deductions to date on the tractor. The taxpayer's basis in this tractor would be $30,000 ($100,000 purchase price less $70,000 accumulated depreciation). If the tractor was destroyed and the insurance company paid a claim of $35,000 to the farmer, the farmer would recognize a $5,000 taxable gain on the insurance proceeds unless every dollar of the $35,000 claim was reinvested in a replacement tractor. If the farmer does not reinvest the proceeds, or if they only reinvest a portion of the proceeds, the taxpayer will pay tax on the portion not invested.
Occasionally, a unique situation arises when the taxpayer receives less in insurance proceeds than their basis in the asset. Continuing our example, let’s assume the farmer’s basis in the tractor is still $30,000 ($100k purchase price less $70k of depreciation taken). What if the insurance company only provides $20,000 of insurance proceeds. The taxpayer would have a casualty loss of $10,000 ($20,000 of proceeds vs. $30,000 of tax basis). How is this casualty loss treated for tax purposes? The taxpayer is allowed to deduct the loss on their business tax return. The timing of the deduction depends on if the loss occurred in a federal disaster area. If the asset was located in a disaster area, the taxpayer can elect to take the loss in the year preceding the event. If the asset was not located in a disaster area, the loss is deducted in the year the loss occurred unless there is a reasonable probability the taxpayer will receive reimbursement for the loss. This loss is then deferred until the taxpayer is confident they will not be receiving any insurance reimbursement for the loss.
A loss arising from casualty or theft of personal property, that is, property not used in a trade or business, is allowed to be deducted on the individual’s tax return (not the farm’s tax return) as an itemized deduction. There are certain limitations involved in taking this deduction, and the taxpayer must be itemizing deductions rather than taking the normal, standard deduction.
Depreciation of Replacement Property
When a taxpayer receives compensation in excess of their basis in the property which has been stolen or destroyed, they can defer taxes by reinvesting the proceeds into a replacement property. However, the downside to reinvesting the proceeds into replacement property is that the taxpayer then has a substituted basis in the new property. Said differently, the taxpayer’s basis in the replacement property is the same basis they had in the damaged property. When taxpayers purchase replacement property that far exceeds their basis in the damaged property, it might be advantageous to pay the taxes on the proceeds now to take a basis in the replacement property equal to the purchase price. This enables the taxpayer to fully depreciate the replacement property & reduce their ordinary income over the taxable life of the asset.
Tax Reform Act – Depreciation Impact
Internal Revenue Code Section 179, passed as part of The Tax Cuts & Jobs Act of 2017 (Tax Reform Act) & subsequently modified by the recently passed CARES Act, allows qualified taxpayers to fully depreciate certain asset purchases immediately in the year of purchase. The maximum amount of Section 179 expense a taxpayer can deduct is $1 million. So, if a farmer purchases a new tractor for $100,000, they can fully depreciate the tractor & deduct the $100,000 in the year of purchase. This is great for taxpayers and incentivizes farms & companies to go out & spend money. One consequence of Section 179 in the scope of this article is that fully depreciating an asset purchase in the year of purchase reduces the tax basis in the asset to zero. Remember, our basis is the purchase price less accumulated depreciation. If a taxpayer depreciates all $100,000 of the purchase price, the tax basis is zero ($100,000 purchase price less $100,000 of depreciation). When a farmer receives insurance proceeds, any amount received in excess of their basis in the asset is taxable income, unless it is reinvested. In our example, if a taxpayer received $75,000 of insurance proceeds on a stolen tractor in the year after purchase, the taxable amount would be $75,000 because the taxpayer has zero tax basis in the property. Again, if the taxpayer rolls that $75,000 into replacement property they can avoid paying tax. The ability to fully depreciate asset purchases in the year of purchase is a huge benefit, but could have a substantial tax consequence in the property is subsequently stolen or damaged.
Farmers should consult their CPA or tax advisor should have damaged, deteriorated, or stolen property. The decision of whether to defer gain or reinvest the proceeds can have substantial tax implications both in the short term and down the road.
This article should not be construed as, and should not be relied upon as legal or tax advice.
Tyler Davis works for SVN: Saunders Ralston Dantzler real estate and also owns his own CPA Firm, Tyler Davis CPA where he provides tax preparation, consulting, and provision services. SVN: Saunders Ralston Dantzler is a leading agricultural land brokerage based in Lakeland, FL. Tyler can be contacted at firstname.lastname@example.org