How to treat insurance payment/loss in taxes

Our association uses a 1120H to file federal taxes and have a question regarding whether to include payments from the insurance company as "exempt function income" or as "other income". Similarly, do the expenses to correct the damage get included in the 90% test for expenditures? Just for background; A fire from another association caused our damage, which our association's insurance company paid to fix. Our association had to cover the deductable. However, our insurance company said they will refund us the deductible, if they recover it from the other association. We're a small association and our only non-exempt income is usualy just pennies in interest income (well below the $100 specific deduction in the 1120H).

Rick, Stuart,

I'll tackle the easier question first. Although I prepare tax returns professionally, DO NOT consider the following as absolute tax advice. For that, you should consult a CPA who can look at your situation more precisely.

First, you need to understand that lines A through E of form 1120-H are not used to calculate any taxes that may be due. They are merely the "information" portion of the return the IRS uses to determine if the HOA is qualified to file form 1120-H. Any and all expenses that qualify as for the 90% expenditure test get reported on line C. That means all expenditures related to the maintenance, operation, repair, etc. of HOA property. It doesn't matter where the money comes from: regular assessments, special assessments, or reserves. DO NOT include the money from insurance reimbursements/proceeds.

Now, on to the more difficult question: What to do about insurance proceeds. Non-exempt income? Or, what?

This gets complicated. There's no place to report such income on 1120-H, nor is there a place for losses due to property damage, etc. Several problems here: One is that filing 1120-H is like filing 1040-EZ. There's no place on Form 1040-EZ to take a deduction for medical expenses, report certain types of income, or claim a deduction for property losses. That means to do this you would have to file Form 1120 instead of 1120-H, but that comes with its own set of problems since any excess income from your regular assessments, such as the money you put into reserves, looks like "profit" and would be taxable, unless you've done some fancy and complicated bookkeeping during the year.

The second problem comes from that fact that it may be difficult, if not impossible, to determine what the adjusted basis is for HOA common property. That has to be the starting point for determine how much, if any, of insurance proceeds are taxable.

Let's look at insurance proceeds:

In general, proceeds from life insurance, or from health insurance used to pay medical expenses, are not taxable. There can be exceptions, but they are rare.

Insurance proceeds to pay for property damage or loss work differently. They may or may not be taxable depending on the circumstances. Furthermore, some people mistakenly believe that if the proceeds exceed what it costs to repair or replace the property, the difference is taxable. That's not exactly how it works, although many times it does come out that way.

In simple terms, property damage/loss proceeds must be used to offset the financial loss because of the property damage/loss. Whether or not the net loss (if any) can be taken as a deduction depends on whether it is personal property or business property. The rules are different. For a simple example, if you have suffered a $10,000 loss of which $8,000 is covered by insurance, you have a net loss of $2,000. Whether or not you can actually deduct that loss depends on whether it is personal or business property.

So, how about your case? Well, for each of you there has been total loss (your cost of repair) minus the amount reimbursed by insurance, leaving you with a net loss, paid for out of your own funds. You have already reported that net loss in the expenses you reported on line C. What about the insurance proceeds? It's a wash. If you had reported it as income somewhere on your return, you would have reported that same amount (either separately or as part of a total) elsewhere on the return. You simply don't need to report it anywhere since you are only reporting the difference (the amount not covered by insurance) as an expense.

So, what if the IRS doesn't agree and says you omitted something? Basically, nothing, other than redoing all the paperwork. Penalties and interest are only assessed on any additional tax due, and since there would be no additional tax due since you would report the insurance proceeds and the added expenses (which are the same and would cancel), there would be no penalties or interest either.

Short answer? Don't worry about reporting the insurance proceeds. Just don't report the amount covered by the proceeds as an expense.

Still, it's best to consult a CPA who can review your individual situation.