August 23, 2024

Taxation of Insurance Proceeds and Involuntary Conversions

C. Robert Holcomb, Extension Educator
Agricultural Business Management, University of Minnesota Extension

Introduction

This article addresses the tax consequences of receiving life insurance payments, property insurance payments related to the farming operation, and handling involuntary conversions.

Taxable Income

Most income is taxable unless it is specifically exempted by law. Income can be money, property, goods, or services. Even if you do not receive a form reporting income, you should report it on your tax return.[1]

Income is taxable when you receive it, even if you do not cash it or use it right away. It is considered your income even if it is paid to someone else on your behalf.

Taxation of Life Insurance

Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, are not includable in gross income.

However, any interest you receive is taxable and you should report it as interest received.[2]

Life insurance proceeds paid to you because of the death of the insured person are not taxable unless the policy was turned over to you for a price. This is true even if the proceeds were paid under an accident or health insurance policy or an endowment contract issued on or before December 31, 1984. However, interest income received because of life insurance proceeds may be taxable. If death benefits are paid to you in a lump sum or other than at regular intervals, include in your income only the benefits that are more than the amount payable to you at the time of the insured person's death. If the benefit payable at death is not specified, you include in your income the benefit payments that are more than the present value of the payments at the time of death.[4]

If you are the policyholder of an employer-owned life insurance contract, you must include in your income any life insurance proceeds received that are more than the premiums and any other amounts you paid on the policy. You are subject to this rule if you have a trade or business, you own a life insurance contract on the life of your employee, and you (or a related person) are a beneficiary under the contract. However, you may exclude the full amount of the life insurance proceeds if the following applies.

  1. Before the policy is issued, you provide written notice about the insurance to the employee and the employee provides written consent to be insured.
  2. Either:
    1. The employee was your employee within the 12-month period before death, or, at the time the contract was issued, was a director or highly compensated employee; or
    2. The amount is paid to the family or designated beneficiary of the employee.[2]

Taxation of Crop Insurance

You must include in your income any crop insurance proceeds you receive as the result of physical crop damage or reduction of crop revenue, or both. You generally include them in the year received. Treat as crop insurance proceeds the crop disaster payments you receive from the

federal government as the result of destruction or damage to crops, or the inability to plant

crops, because of drought, flood, or any other natural disaster.

You can postpone reporting some or all crop insurance proceeds as income until the year following the year the physical damage occurred, if you meet all the following conditions.

  • You use the cash method of accounting.
  • You receive the crop insurance proceeds in the same tax year the crops are damaged.
  • You can show that under your normal business practice you would have included more than 50% of the income from the damaged crops in any tax year following the year the damage occurred.

Proceeds received from revenue insurance policies may be the result of either yield loss due to physical damage or to decline in price from planting to harvest. For these policies, only the amount of the proceeds received because of damage or destruction (yield loss) can be deferred. Proceeds received from weather insurance policies cannot be deferred if the payment is based on rainfall amounts and is not a result of physical damage to a crop. To postpone reporting some or all crop insurance proceeds received in 2024, report the amount you received on Schedule F, line 6a, but do not include it as a taxable amount on line 6b. Check the box on line 6c and attach a statement to your tax return. The statement must include your name and address and contain the following information:

  • A statement that you are making an election under section 451(f) and Regulations section 1.451-6.
  • The specific crop or crops physically destroyed or damaged.
  • A statement that under your normal business practice, you would have included more than 50% of the income from some or all of the destroyed or damaged crops in gross income for a tax year following the year the crops were destroyed or damaged.
  • The cause of the physical destruction or damage and the date or dates it occurred.
  • The total payments you received from insurance carriers, itemized for each specific crop, and the date you received each payment.
  • The name of each insurance carrier from whom you received payments.

One election covers all crops representing a single trade or business. If you have more than one farming business, make a separate election for each one. For example, if you operate two separate farms on which you grow different crops and you keep separate books for each farm, you should make two separate elections to postpone reporting insurance proceeds you receive for crops grown on each of your farms. An election is binding for the year unless the IRS approves your request to change it.

Involuntary Conversion

An involuntary conversion is the compulsory or involuntary conversion of property into similar property, dissimilar property, or money, due to the property’s destruction, theft, seizure, requisition, or condemnation (actual or threatened).[5]

Where property is involuntarily converted into money (i.e., insurance proceeds for the property or disaster relief) or into property that is not similar or related in service or use, the taxpayer may defer tax on any gain, if the replacement property is purchased within the statutory replacement period of the two years which follow the year of the event.

Cross Reference:  See the RuralTax.org fact sheet titled, “Disaster Losses and Related Tax Rules” at https://extension.usu.edu/ruraltax/tax-topics/disaster-losses-2023

The cost of the replacement property must be equal to or more than the net proceeds from the converted property, and the replacement must generally be made within two years after the close of the first tax year in which any part of the gain is realized.[6]

Report an involuntary conversion of business assets on Form 4797.

Example 1: 

Johnny Jones is a farmer from middle Tennessee.  His machine shed was destroyed by a tornado in February 2022.  The destroyed machine shed was five years old but had zero basis because Johnny took bonus deprecation on the structure when it was originally constructed.  Johnny received a $100,000 insurance settlement to replace the machine shed.  If Johnny replaces the machine shed before the end of 2024, and spends $100,000 or more on the replacement property, he is not required to claim the insurance payment as income.

If Johnny spends $120,000 on the replacement building, then Johnny’s new basis in the building will be $20,000 (the amount more than the insurance payment).  Johnny will begin depreciating the $20,000 for the building when the structure is placed in service.

If Johnny only spends $ 75,000 on the replacement building, then Johnny will have a $25,000 recognized gain on the transaction ($100,000 insurance payment less $75,000 spent on the replacement structure).  This gain is reportable in the year of the disaster or in the year the insurance proceeds were received (this could happen if the disaster is at the end of the calendar year).  Johnny would report the $25,000 gain on Form 4797.

Immediately after the storm, Johnny plans to replace the structure and does not report the insurance proceeds as income in 2022.  Midway through 2024, Johnny changes his mind and will not replace the machine shed damaged by the tornado.  Johnny must go back and amend his 2022 Federal Tax Return and add the income received from the insurance settlement.


Taxation of Insurance Proceeds

You may deduct casualty and theft losses relating to your home, household items, and vehicles on your federal income tax return if the loss is caused by a federally declared disaster. You may not deduct casualty and theft losses covered by insurance, unless you file a timely claim for reimbursement, and you reduce the loss by the amount of any reimbursement or expected reimbursement.[7]

You must reduce the loss, whether it is a casualty or theft loss, by any salvage value and by any insurance or other reimbursement you receive or expect to receive. The adjusted basis of your property is usually your cost, increased or decreased by certain events such as improvements or depreciation.[8]  For more details on personal casualty losses and thefts, see IRS Publications 547, Casualties, Disasters, and Thefts.

Example 2: 

Joe Smith owns a barn that was damaged in a hailstorm.  In this case, the hailstorm damage was limited to only the roof.  Joe received a $30,000 insurance payment for the damage.  Joe, in turn, hired a contractor to repair the roof.  The repair bill from the contractor totaled $35,000.  Since Joe spent more than the insurance proceeds on the repair, he is not required to claim any of the insurance payment as income.  Joe will add $5,000 to the basis of his barn ($35,000 repair less $30,000 insurance payment). 

If Joe had only spent $25,000 on the roof repair, he would need to claim $5,000 of the insurance payment as income ($30,000 insurance payment less the $25,000 repair). 

The rules for reporting insurance payments from damage to business assets or involuntary conversions are complicated.  Please consult your tax professional when dealing with these types of transactions.

IRS Publications

IRS forms and publications can be found by going to www.irs.gov and typing in the name of the publication/form or the publication/form number in the search bar toward the top of the webpage. Publications may be viewed online or downloaded.

Additional Topics

This fact sheet was written as part of Rural Tax Education, a national effort including Cooperative Extension programs at participating land-grant universities to provide income tax education materials to farmers, ranchers, and other agricultural producers. For a list of universities involved, other fact sheets and additional information related to agricultural income tax please see RuralTax.org.

 

[1] Internal Revenue Website.  https://z.umn.edu/Taxable_Income

[2] Internal Revenue Website.  https://z.umn.edu/Life_Insurance

[3] IRS Publication 525.  p. 23.  https://www.irs.gov/publications/p525

[4] Ibid.  p. 23.

[5] Internal Revenue Code §1033(a)

[6] Internal Revenue Code §1033

[7] Internal Revenue Website.  https://www.irs.gov/taxtopics/tc515

[8] Ibid.



This information is intended for educational purposes only. You are encouraged to seek the advice of your tax or legal advisor, or other authoritative sources, regarding the application of these general tax principles to your individual circumstances. Pursuant to Treasury Department (IRS) Circular 230 Regulations, any federal tax advice contained here is not intended or written to be used, and may not be used, for the purpose of avoiding tax-related penalties or promoting, marketing or recommending to another party any tax-related matters addressed herein.

USDA is an equal opportunity provider, employer, and lender. Rural Tax Education is part of the National Farm Income Tax Extension Committee.  The land-grant universities involved in Rural Tax Education are affirmative action/equal opportunity institutions.

This material is based upon work supported by the U.S. Department of Agriculture, under agreement number FSA21CPT0012032. Any opinions, findings, conclusions, or recommendations expressed in this publication are those of the author(s) and do not necessarily reflect the views of the U.S. Department of Agriculture. In addition, any reference to specific brands or types of products or services does not constitute or imply an endorsement by the U.S. Department of Agriculture for those products or services.

Published August 2024

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This information is intended for educational purposes only. You are encouraged to seek the advice of your tax or legal advisor, or other authoritative sources, regarding the application of these general tax principles to your individual circumstances. Pursuant to Treasury Department (IRS) Circular 230 Regulations, any federal tax advice contained here is not intended or written to be used, and may not be used, for the purpose of avoiding tax-related penalties or promoting, marketing or recommending to another party any tax-related matters addressed herein.