Kelly Bullis: Involuntary conversion of a personal residence

There is something called an “involuntary conversion” in IRS code section 121. If you were forced to leave your personal residence, unplanned on your part, that is called an “involuntary conversion.” (Government eminent domain, easement, fire, flood, wind, etc.) The proceeds you get from insurance, etc., can be considered proceeds on the “sale” of your home that qualify for using IRS code section 121 to eliminate tax on all or part of the gain from losing your home.

Anybody lose a home in California fires in the last few years? Did you get insurance and government funds to compensate you for the loss of your home? Do you still own the land, but it is bare, nothing left of value, the area around your land looks like a nuclear bomb went off, there are no potential buyers for that land. Sounds like “Paradise Lost.” Hmmm?

Let’s go over a real-life scenario. A couple owned a home in a place in California that suffered a horrible fire five years ago. The whole town was burned up! Some folks lost their lives. The state of California set up a fund to compensate the good folks of this devastated town. In typical fashion, government is slow at actually rendering assistance. In 2022, California finally started issuing checks to qualified residents, after deducting about 1/3 to pay attorneys that the state hired to facilitate this fund’s actions.

California passed a law that said these funds were not taxable in California, but the IRS concluded that they were for federal tax purposes. Under current federal law, you do not get to deduct legal fees paid, so these poor folks, who lost their homes over five years ago, now are being told they must pay tax on the gross proceeds. Let’s say our “couple” got $360,000 gross, but paid the attorney fees of $100,000, so they only netted $260,000. IRS wants them to pay tax on the $360,000.

Hey, they’re doing their job, why should the IRS voluntarily inform these folks about the “involuntary conversion” provision of Section 121? Now, using this code section, our valiant couple can consider their home as being sold and compute all costs to sell, including $100,000 attorney costs, to compute the gain on sale, then reduce the taxable gain by $500,000 (the gain exclusion for couples under IRS Code section 121 … $250,000 for single folks) and voila, no taxable gain!

But wait, you still own the land. Is it really worth anything? Would you buy land in the middle of a place wiped out by a nuclear bomb? The land, for all intents, is worthless. You can now hold it, paying a pittance of property tax on it every year, waiting for others to rebuild the town, plant new trees, etc. Maybe in 20 years, you could sell that land and recoup your property taxes paid and then some? At that point, the sales proceeds would be 100% taxable, but at long-term Capital Gains tax rates. (By the way, elect to add the property tax to your basis every year.)

Not a bad ending after all for our valiant couple who lost everything and are now slowly rebuilding their lives. That’s 1 for the taxpayer and 0 for the IRS. Gotta love it when things can turn out better than expected.

Have you heard? Ecc 3:6 says, “…a time to seek, and a time to lose; a time to keep, and a time to cash away.”

Kelly Bullis is a Certified Public Accountant in Carson City. Contact him at 882-4459. On the web at BullisAndCo.com. Also on Facebook.