Will the IRS tax on wildfire regulations be blocked by Congress?

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Most legal settlements are taxable, even for a devastating fire claim. This grim fact can come as a nasty surprise to fire victims and seems particularly unfair. There are pending federal and California tax bills that, if passed, could make certain fire lawsuit recoveries non-taxable. It’s unclear how any of these bills will fare, but a large number of tax bills are introduced that never pass. In this sense, statistics alone do not bode well. The Federal Project invoice was introduced by Congressmen Doug LaMalfa (R – California) and Mike Thompson (D – California) and would exempt thousands of fire victims who receive compensation from the PG&E Fire Victim Trust from paying federal income tax on their colonies. There is also a California bill, AB 1249, authored by Assemblyman James Gallagher, that would add a similar exemption from California state taxes. But unless and until both provisions are passed, fire victims must account for their fire recoveries when doing their taxes.

That doesn’t mean paying taxes on every dollar. In some cases, no part of the recovery will actually be subject to current taxes. But it can take considerable ingenuity to turn the gross settlement figure into a viable and defensible tax reporting strategy with the IRS and (for Californians, with the Franchise Tax Board). Victims of fire must account for everything, including attorney fees. Most fire plaintiffs use contingency fee attorneys. Contingent legal fees may be paid separately to the plaintiff’s attorneys, but are still allocated to the plaintiff for tax purposes. How is it legal fees are treated under tax law.

Until 2018, it was clear that legal fees were almost always tax deductible. However, under the Tax Cuts and Jobs Act passed at the end of 2017, many legal fees are no longer deductible. Various itemized deductions, which accounted for most legal fees, have been repealed for the 2018 through 2025 tax years. As a result, in some cases claimants may not be able to deduct fees, even if 40% or more of their recoveries go to their lawyers. Of course, lawyers also have to pay tax on fees, so some claim this is a form of double taxation. In any event, the tax treatment of legal costs has become a major tax issue associated with many types of litigation, but there are 12 Ways to Deduct Legal Fees Under New Tax Laws.

Fortunately, for fire victims, for federal and California income tax purposes, there is usually a good way to deduct or offset legal fees. While fire salvage can be treated as a capital gain, which is usually the case, legal fees can be treated as an additional basis in the home or as a selling expense. This may mitigate the treatment of legal fees by the new tax law. In effect, this may mean paying tax only on the net recovery. Of course, that still leaves a lot of tax issues to deal with. How fire victims are taxed depends on their situation, what they ultimately collect and what they claim on their taxes. Both the IRS and the California Franchise Tax Board require annual tax filings, but a whole slew of tax years can be peppered with elements of fire, including insurance recoveries.

Say you lose a $1 million house, but you get $1 million back from your insurance company or PG&E. He could his like there’s nothing to tax, since you lost a $1 million house and just got $1 million back. However, you need to know your taxation base in the property. This usually means the purchase price plus the cost of subsequent upgrades. If it was commercial property, you’ll need to account for depreciation (and recapture of depreciation).

But even with a personal-use property like a house, your base matters. The property may have been worth $1 million at the time of its destruction, but if the original purchase price plus improvements was only $100,000, there is a gain of $900,000. Does that mean our fire victim has to pay taxes on the $900,000 gain? Not necessarily. Fortunately, subject to requirements and limitations, tax law can treat this as an involuntary conversion despite the $900,000 gain. If you qualify, you can apply your old tax base of $100,000 to a replacement home. That means you shouldn’t have to pay tax on that $900,000 gain until you eventually sell the replacement residence. In order to defer a gain in the event of a claim by reinvesting insurance or litigation proceeds, the replacement property must generally be purchased within two years of the close of the first year in which any part of the gain in losses is realized. For a declared Federal Catastrophe, the period is extended to four years. To see Which property is eligible for the involuntary conversion tax relief.

However, be aware of insurance recoveries, which can occur long before a lawsuit is settled. If your insurance company has paid you enough money to create even a dollar of taxable gain on your destroyed property, the time needed to acquire a replacement property may have already begun. Another big issue is claiming a casualty loss. Until 2018, many taxpayers could claim accident losses on their tax returns. But starting in 2018 and continuing through 2025, personal losses are only allowed if your loss results from a federally declared disaster. Many California wildfire victims are eligible because most large California wildfires are federally declared disasters. Even so, there can still be careful planning and screening to determine if claiming a loss is a good decision.

Another tricky question is how to handle temporary housing and similar expenses. If your principal residence is damaged or destroyed, your insurance product intended to compensate you for your living expenses may be partially exempt from tax. Examples are alternative housing and food. But, if the insurance proceeds reimburse you for living expenses, you would have normally incurred if your house had not been damaged, say your mortgage payment or your typical food expenses, this part may be taxable Income for you. If the insurance proceeds exceed the actual amount you spend on temporary housing, food and other living expenses, that excess may also be taxable.

As these examples illustrate, even the treatment of insurance proceeds raises many nuanced tax issues. Obviously, however, the tax issues and problems can get worse with a recovery. For victims who end up receiving a legal settlement or judgment, how will it be taxed? Fire recoveries are extremely factual, so the issues are complex to assess how a fire recovery will be taxed. Some fire cases involve wrongful death and compensatory damages for wrongful death are not taxable. Punitive damages are always taxable. Some victims suffer physical injuries or physical illnesses, caused by the fire or exacerbated by it. Fortunately, Section 104 of the tax code excludes from income damages for physical injury or physical illness. The damage must be physical, not just emotional, for the money to be tax exempt.

Health problems due to smoke inhalation or exacerbation of pre-existing medical conditions may be sufficient for non-taxable damages. Some of the plots that the tax law seems to require may seem contrived. Most damages related to emotional distress are fully taxable, but emotional distress triggered by physical injury or physical illness is tax exempt. It can do taxing emotional distress and damage from physical illness can be like a chicken or an egg issues.

The big issue in most fire cases is the damage or destruction of property. It can be a multi-faceted element, with a house, outbuildings, trees and shrubs, crops and more. The actions of the taxpayer are also important to consider. Are you rebuilding or moving? All of this will affect how the IRS will tax the victim of a fire. If you don’t reinvest, you can realize a big capital gain, subject to claiming up to $500,000 of the principal residence tax benefit if you qualify. If you sell a principal residence and qualify, the first $500,000 of gain for a married couple filing jointly should be tax exempt. The balance should be taxed as a capital gain. But keep in mind that this is only a federal tax benefit. When it comes to California taxes, remember that all income is taxed up to 13.3%, so even capital gain isn’t a bargain.

Understandably, many fire victims hope to pay no taxes when they collect money from their insurance company, PG&E, or Edison. If they spend their proceeds on buying a new home or rebuilding, they may end up with a weak base in the new home, but that would mean paying taxes much later when they finally sell their home. But there can be surprising pitfalls in fire cases that are important to avoid. In any fire recovery, pay careful attention to timing and detail. When it comes to taxes, just like when it comes to fire, be careful.

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