When a personal residence is destroyed by fire, the IRS treats the event as an involuntary conversion. Special tax rules may allow you to defer or avoid paying tax on the gain, depending on how you use the insurance proceeds.
Let’s walk through a sample scenario. Assume a home purchased 15 years ago, with a cost basis of $190,000, is destroyed in 2025. The home was valued at $600,000 on the day of the fire. Insurance proceeds received in 2025 for the destruction of the home totaled $500,000.
Unfortunately, the loss of $100,000 in potential profit (had the home been sold before the casualty for its fair market value) is not deductible.
Generally, insurance proceeds for destroyed personal property (the contents inside the home) are not taxable. We are addressing only the real property in this discussion.
1. Do You Have a Taxable Gain?
Your numbers:
- Adjusted basis in the home: $190,000
- Insurance proceeds received: $500,000
Realized gain: $500,000 – $190,000 = $310,000
So yes, you have a realized gain of $310,000. However, realized gain is not the same as taxable gain. Whether part or all of the realized gain is taxable depends on what you do with the insurance proceeds, and when.
2. Can You Avoid Tax by Reinvesting the Insurance Proceeds?
Yes. Under Internal Revenue Code §1033, you can defer tax on the gain if you reinvest the insurance proceeds in qualified replacement property. To qualify:
- The replacement property must be similar or related in service or use
- For a personal residence, this generally means another home you will use as your principal residence
If you reinvest all $500,000 (or more) into:
- Buying a replacement home, or
- Building a new home,
Then, you can defer the entire $390,000 gain.
Important note: If you reinvest less than $500,000, part of the gain becomes taxable.
Here is an example:
- Reinvest $460,000 in a replacement home
- Underinvested amount: $40,000 ($500,000 – $460,000)
- Taxable gain: $40,000 (limited to the $310,000 total gain)
3. How Long Do You Have to Buy or Build a Replacement Home?
For a home destroyed by fire, you generally have two years to replace the property.
The replacement period:
- Starts: On the date of the fire
- Ends: Two years after the end of the tax year in which you realized the gain. That typically would be the year you received the insurance proceeds. (NOTE: If there was a federally declared disaster for the area where the property was destroyed, the replacement period is extended to a total of four years.)
In practice, for most homeowners, this typically covers up to three years.
Here is an example. If the fire occurred in January 2025, and the insurance proceeds were received in November 2025, the replacement period ends December 31, 2027.
This applies whether you:
- Purchase an existing home, or
- Build a new one (or complete construction within the two-year period)
4. What Happens to Your Basis in the New Home?
If you defer the gain, it doesn’t disappear; it’s rolled into the basis of the replacement property. In other words, the new home’s basis equals the cost of the replacement residence MINUS the deferred gain.
This matters later if you sell the replacement home. Remember, if you meet the qualifications, the $250,000 / $500,000 home sale exclusion for the sale of a personal residence may still apply at that time.
5. Key Takeaways
- ✔ You realized a $310,000 gain
- ✔ The gain is not taxable if you reinvest all the insurance proceeds properly and timely
- ✔ You must reinvest in a similar property (another personal residence)
- ✔ You typically have up to two years after the tax year in which you receive the insurance proceeds
- ✔ Partial reinvestment of the insurance proceeds may result in partial taxation of the insurance proceeds.
Because timing, documentation, and the mandatory election statement on your tax return matter under §1033, it’s wise to work with a professional, especially if construction timelines or partial reinvestment are involved.
6. How do I make the election to defer the gain?
To defer the gain under Internal Revenue Code Section 1033 (involuntary conversion) after your house was destroyed by fire and you received insurance proceeds:
✅ Attach a Statement to Your Federal Tax Return
You make the §1033 election by attaching a statement to your federal income tax return for the year in which you received the insurance proceeds and realized the gain. This statement informs the IRS that you intend to defer recognition of the gain because you will replace the property within the statutory replacement period (typically 2 years after the tax year in which the gain is realized).
What the Election Statement Should Include
Your statement must be detailed and cover all relevant facts. At a minimum, it should include:
📍 Identification Information
- Your full name, including spouse, if a joint election.
- Social Security Number (SSN) (for both taxpayers if a joint election)
- Current mailing address and contact phone number
📍 Details of the Involuntary Conversion
- Description of the destroyed property
- Date of the fire
- Amount of insurance proceeds received
- Adjusted basis of the destroyed property (original cost plus improvements, minus depreciation, if any, for a rental or office in the home)
- Calculation of gain realized ($500,000 insurance − $190,000 basis = $310,000 gain in our example)
📍 Intent to Reinvest
- A clear statement of your intent to replace the converted property with a replacement home (or improve one or build one) that is “similar or related in service or use.”
📍 Timeline Acknowledgment
- Your acknowledgment that you understand the replacement period deadline (generally two years after the close of the tax year in which the gain is realized).
📍 If Replacement Isn’t Acquired Yet
If you haven’t bought or started building the replacement property by the tax return due date, your statement should also include:
- That you intend to acquire replacement property within the replacement period, and
- That you want to defer the gain under §1033.
The IRS considers this a “protective election” because it preserves your right to defer the gain even though replacement isn’t complete yet.
When to File the Election
- Attach the election statement to your Form 1040 (or 1040-SR) for the year you received the insurance proceeds and realized the gain.
- If you acquire the replacement property in a later year:
- Attach a second statement to that year’s tax return showing the cost of the replacement property and the deferred gain calculation.
Checklist: What to Document & Keep
You should keep the following records for your files and for the IRS (especially if audited):
📌 Documents Showing the Involuntary Conversion
✅ Insurance policy
✅ Insurance settlement statement (Form or Statement showing $300,000 received)
✅ Proof of destruction (fire report, photos, etc.)
✅ Closing settlement statements for sale or conversion
📌 Cost and Basis Records
✅ Original purchase contract of the old home
✅ Records of improvements (receipts, contractor statements)
✅ Evidence of adjusted basis calculations
📌 Tax Return Attachments
For the year you make the election:
- The §1033 election statement
- Form 4684, Casualties and Thefts (if applicable)
- Form 4797, Sales of Business Property (if needed for reporting the gain; for personal residence the gain may flow differently)
- Any worksheets used to calculate realized gain (insurance proceeds less basis)
📌 Replacement Property Documentation
When you acquire the new home:
✅ Purchase contract(s)
✅ Closing statement (HUD-1 or Closing Disclosure)
✅ Proof of payment
✅ Construction contracts/receipts (if building)
Attach:
- A follow-up statement on your tax return for the year you acquire the replacement property, showing how much was spent and that it qualifies under §1033.
Keep in Mind
- This is an election; it is not automatic. If you do not attach the statement, the IRS may treat you as not having elected to defer the gain.
- If you fail to replace the property in time or replace it for less than the insurance proceeds received, some of the gain becomes taxable. In that case, you will need to file an amended return (e.g., Form 1040-X) for the year of the gain.
- Always retain copies of everything (statements, receipts, tax attachments, and correspondence) for the full replacement period plus any applicable statute of limitations.
- If you are selected for audit, be sure to retain the original documents.
Here’s a sample Section 1033 election statement you can adapt and attach to your federal tax return (Form 1040 or 1040-SR for the year you received the insurance proceeds). This wording follows how taxpayers typically describe the involuntary conversion and election to defer gain under IRC §1033 as discussed in IRS guidance and tax practice.
SAMPLE ELECTION STATEMENT — IRC §1033 (INVOLUNTARY CONVERSION)
Tax Year: _______
Taxpayer: ___________________________ (Your Full Name)
Social Security Number: ––____
Address: ____________________________________________
Re: Election under Internal Revenue Code Section 1033 for Involuntary Conversion of Personal Residence
Pursuant to Internal Revenue Code §1033(a)(2) and the related Treasury Regulations, the taxpayer hereby elects to defer recognition of gain realized on the involuntary conversion of property as described below.
- Description of Involuntary Conversion
On or about [Date of Fire], my personal residence located at [Full Address of Destroyed Property] was destroyed by fire (an involuntary conversion). I received insurance proceeds as compensation for the loss.
- Insurance Proceeds and Adjusted Basis
Total insurance proceeds received as a result of this involuntary conversion: $500,000.
Adjusted basis of the converted property: $190,000.
- Realized Gain
The realized gain from this involuntary conversion equals the insurance proceeds received minus the adjusted basis of the converted property (i.e., $500,000 − $190,000 = $110,000 gain).
- Replacement Property
I intend to purchase or construct a replacement personal residence that is similar or related in service or use to the property so converted. I understand that, under IRC §1033, gain shall be recognized only to the extent that the amount realized on the conversion exceeds the cost of such replacement property if acquired within the replacement period.
You must complete the replacement within the replacement period provided by law — generally two years after the close of the first taxable year in which any part of the gain upon the conversion is realized.
- Election
I hereby elect under IRC §1033(a)(2) to defer the recognition of gain realized on the involuntary conversion described above by acquiring qualified replacement property within the statutory replacement period.
- Supporting Attachments
Copies of the insurance settlement statement and evidence of the involuntary conversion event are attached.
Signature: _________________________
Date: _____________________________
📌 Tips for Using This Statement
- Attach this statement to your federal income tax return for the year you received the insurance proceeds and realized the gain.
- Also include supporting documentation:
- Insurance settlement or payout details
- Photos or official documentation of the fire
- Basis calculation for the destroyed property
- If you haven’t yet bought or built the replacement home by the tax return deadline, this wording expresses your intent to replace it within the statutory period (protective election).
Finally, for a California involuntary conversion, it appears that the replacement property can be located in another state. I found nothing that requires the replacement property to be located in California.