In a federally declared disaster area, specific tax rules apply to insurance proceeds received for a principal residence that is involuntarily converted (e.g., destroyed by wildfire).

Unscheduled Personal Property

If you receive insurance money for unspecified personal belongings inside your primary home, you do not recognize a gain for tax purposes, given that this property wasn’t specifically listed (“scheduled”) in your insurance policy.

Example: After a wildfire, you receive $5,000 from your insurance company to cover the cost of replacing clothing, kitchenware, and other non-scheduled personal items damaged in your primary residence. You do not need to report this as a gain on your taxes.

Insurance Payments for Living Expenses

For the most part, money received from both insurance companies and government sources in a federally declared disaster area is not taxable, but there are some important exceptions:

Non‑Taxable Payments

• Insurance payments for living expenses: In a federally declared disaster area, none of the insurance payments for temporary living expenses are taxable, BUT MAY if they exceed your actual increased expenses. [Publication 547, 26 U.S. Code § 123,Code § 139]
• Qualified disaster relief payments FOR EXPENSES NOT COVERED BY INSURANCE: Government payments to help with reasonable and necessary expenses (personal, family, living, funeral, home repair/rehabilitation, or replacement of contents) are not taxable. [Publication 547; 26 U.S. Code § 139]
• Stafford Act grants: Disaster relief grants received under the Stafford Act are generally not included in income [Publication 547, 26 U.S. Code § 139].

Taxable Payments

• Disaster unemployment assistance payments: These are specifically noted as being taxable unemployment benefits, even in a federally declared disaster area. [Publication 547].
• Income replacement payments: Qualified disaster relief payments do not include income replacement payments, such as payments of lost wages, lost business income, or unemployment compensation. These would generally be taxable. [Publication 547, 26 U.S. Code § 139].
• Business payments: Payments to businesses generally don’t qualify for the tax exemption. [Publication 547, 26 U.S. Code § 139]

Reference to Section 139

• Gross income shall not include any amount received by an individual as a qualified disaster relief payment.
• The term “qualified disaster relief payment” means any amount paid to or for the benefit of an individual to reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster.

Loss of Dwelling and Scheduled Property

Insurance money you receive for your home or its contents (excluding the unscheduled personal property mentioned above) is seen as payment for a single asset (IRC Section 1033(h)). Any item that offers similar utility or function as the residence that was impacted will be viewed as being similar to that single item for tax purposes.

Lender Escrow Requirements

If you have a mortgage on your property, your lender has a financial interest in ensuring the property is repaired or rebuilt. As a result:

• The insurance company may issue checks payable to both you and your mortgage lender
• Your lender may hold the insurance proceeds in an escrow account
• The lender typically releases funds in installments as repairs progress, requiring:
  • Documentation of work completed
  • Inspection of repairs
  • Contractor invoices and receipts
• Final payment is usually released when repairs are complete and pass inspection

This escrow process helps protect both the homeowner and lender by ensuring insurance proceeds are properly used for repairs or rebuilding.

Scenario

A primary residence is destroyed by a wildfire in a federally declared disaster area. The family holds a homeowner’s insurance policy.

Scheduled Property Example

Scheduled property refers to items specifically listed on an insurance policy. These items are typically high-value and may include:

• Jewelry (e.g., rings, necklaces, watches)
• Fine art (e.g., paintings, sculptures)
• Collectibles (e.g., rare coins, stamps, baseball cards)
• Furs
• Antiques
• Musical instruments

Insurance Payout as a Single Fund

In the event of a total loss like the one described, the insurance company will likely determine the replacement cost of the home and the value of the scheduled property. Here’s how the insurance proceeds would be considered a single payout:

Extended Replacement Period

You usually have two years to reinvest insurance money into a replacement property to avoid paying taxes on the gains. However, if your property is in a federally declared disaster zone, you now have four years to reinvest the money.

Example: If your home was destroyed in a federally declared disaster area, you generally have four years from the end of the tax year in which you realized a gain from the insurance proceeds to reinvest in a similar property.