Important Tax Considerations Following Nebraska Wildfire and Drought Losses
We are reaching out in light of the recent wildfires and drought conditions affecting parts of Nebraska, including areas that have been designated as federally declared disaster areas. We know many individuals, families, farmers, ranchers, and business owners are dealing with difficult decisions right now, and we want to highlight an important tax issue that is easy to overlook: insurance proceeds and other recovery payments can sometimes create taxable income, even when the payments are intended to help you recover from a loss.
At a high level, if property is destroyed, damaged, or sold because of a disaster, and you receive insurance proceeds or other payments that are more than your tax basis in that property, a taxable gain can arise. This can happen with a home, outbuildings, commercial buildings, machinery, equipment, vehicles, breeding livestock, or other business and investment property. In other words, receiving money after a fire or drought event does not always mean the tax result is neutral. The good news is that IRC §1033, the involuntary conversion rule, may allow you to postpone recognizing that gain if you use the proceeds to acquire qualifying replacement property within the allowed time and properly make the election.
In plain English, an involuntary conversion generally means your property was destroyed, damaged, condemned, or otherwise affected by an event outside your control, such as fire or drought, and you receive insurance or other compensation as a result. If the rules are met, you may be able to defer gain by reinvesting those proceeds in replacement property. The replacement rules are very fact-specific, but in federally declared disaster areas there is often added flexibility, especially for business or investment property, in what may count as qualifying replacement property. There can also be longer replacement periods in certain situations, including for principal residences damaged in a federally declared disaster and for certain livestock sold because of drought. In many cases the replacement period is at least two years, but special rules can extend that period to three, four, or even longer depending on the type of property and the circumstances . One important point is that a tax deferral is not the same as tax forgiveness: when gain is deferred, the replacement property generally starts with a lower tax basis, which can affect future depreciation and future gain when that replacement property is later sold .
For our farm and ranch clients, there are additional points to keep in mind. If livestock are sold because drought conditions make it necessary to reduce herd size, gain on excess sales may, in some cases, be deferred if replacement animals—or in certain circumstances other qualifying farm property—are acquired within the extended replacement period. The IRS may also issue annual guidance extending replacement periods for areas experiencing prolonged drought, which can be especially important for producers in affected Nebraska regions.
