Taxing Wildfire Lawsuit And Insurance Recoveries

• Published date: 19 January 2024
• Subject Matter: Intellectual Property, Tax, Copyright, Income Tax, Corporate Tax, Capital Gains Tax
• Law Firm: Wood LLP
• Author: Mr Robert W. Wood and Alex Brown

If you have lost loved ones in a fire or other disaster, taxes are the least of your worries. If your loss is limited to your house and personal possessions, you may not think about taxes until tax time. Even businesses that always have taxes in mind have so much to try to reconstruct or replace that tax considerations usually come much later.

There are more immediate concerns in the weeks and months following a fire. But tax issues eventually arise, and it is good to be prepared for them. Insurance proceeds can raise tax issues, as can other recoveries such as lawsuit settlements.

Hawaii fire victims may be a long way from receiving any lawsuit compensation, but when they do, they may look to the experience of Californians who also experienced devastating wildfires in the last decade. Thousands of Californians have had to sort out ' and are still sorting out ' the complicated tax interactions between insurance payments, casualty loss deductions, legal recoveries from defendants such as utility companies, and rebuilding expenses. As lawsuits and insurance claims are filed, it is important to think of the tax man, too.

Most legal settlements are taxable, even for a devastating fire loss. A federal tax bill was introduced by U.S. Reps. Doug LaMalfa, R-Calif., and Mike Thompson, D-Calif., that would exempt compensation from federally declared wildfires from federal income tax.¹ This legislation was folded into a broader disaster relief tax bill that recently cleared a committee and moved to the House floor.² It has a long path ahead to enactment, though many ' including the trustee of the PG&E Fire Victim Trust ' have written letters in support to Congress.

California Exclusions for Fire Victims

California lawmakers have passed four exclusions to the Revenue and Taxation Code for certain fire recoveries. First, A.B. 1249, authored by Assembly member James Gallagher (R), created an exemption for Fire Victim Trust recoveries. California also enacted S.B. 1246 to exempt settlement payments from Southern California Edison for the Thomas and Woolsey fires.

Two further California income tax exclusions ' for the 2019 Kincaid fire and the 2020 Zogg fire ' were enacted as part of an omnibus bill, S.B. 131. The somewhat piecemeal method by which the state has added these exclusions can make it difficult for fire victims to keep up with which fires qualify for this tax relief. Thankfully, the four new Revenue and Taxation Code sections (sections 17138.5, 17138.6, 17139.2, and 17139.3) added to establish the exclusions were placed directly next to each other in the California code. Corresponding corporation tax provisions were also added with sections 24309.1, 24309.3, 24309.6, and 24309.7.

Of course, the Legislature can only create state income tax exclusions, not federal. Therefore, victims of the Thomas, Woolsey, Kincaid, and Zogg fires, as well as fire victims receiving recoveries from the PG&E Fire Victim Trust or residing in other states, must consider their fire recoveries when filing their federal taxes.

Federal Taxes and Legal Fees

Most fire victim plaintiffs hire contingent-fee lawyers. Contingent legal fees may be separately paid to the plaintiff lawyers, but they are still attributed to the plaintiff for tax purposes.³ Thus, after reporting a gross settlement amount including legal fees, plaintiffs need a way to deduct the legal fees.

Until 2018, legal fees were usually tax deductible as miscellaneous itemized deductions.⁴ Taxpayers often tried to qualify for better, above-the-line deductions for their fees and expenses,⁵ but the below-the-line deduction was essentially always a safe and reliable contingency option. However, under the federal Tax Cuts and Jobs Act enacted in late 2017, miscellaneous itemized deductions were suspended for tax years 2018 through 2025.⁶

Accordingly, in some cases, plaintiffs may not be able to deduct the fees, even though 40 percent or more of their recoveries are paid to their lawyers.

The above-the-line deductions taxpayers tried to claim before the TCJA still exist, but the tax treatment of the legal fees has become a major tax problem associated with many types of litigation.⁷

Fortunately for fire victims, there is usually a good path to deduct or offset the legal fees. Under IRC section 1033, insurance and other proceeds received that compensate you for damage to your property in a fire or other involuntary conversion are generally treated for tax purposes as a capital recovery, like sales proceeds. Typically, the bulk of insurance proceeds and legal recoveries received for a fire are for damage to property. In addition to the other benefits that section 1033 and capital gain treatment may provide, this treatment helps to mitigate the legal fee problem.

To the extent the fire recovery can be treated as a capital recovery,⁸ the legal fees can be treated as additional basis in the home or other property damaged by the fire, or as a selling expense.⁹ Capitalizing the legal fees reduces the resulting capital gain on the recovery,¹⁰ thus having a similar offsetting effect on capital gains that deductions have on ordinary income. However, capitalization is not affected by the suspension of miscellaneous itemized deductions. Of course, that still leaves plenty of tax issues to address.

Untangling Basis, Gain, and Income

How fire victims are taxed depends on their circumstances, what they collect, and what they claim on their taxes. Suppose that you lose a $1 million home but collect $1 million from your insurance carrier or as lawsuit proceeds. Since you lost a $1 million home and simply got $1 million back, it might sound like there is nothing to tax. You have only broken even.

However, that is not how tax law views it. To determine whether you've made a profit, tax law looks at how much you paid for and have invested into your home. If you only paid $400,000 for the home (the original purchase price plus the cost of renovations and other improvements) and now you've...