Tax Tips for Fire Victim’s Trust Recipients

iStock/Jirapong Manustrong

As of November 1, the PG&E Fire Victims Trust (FVT) has paid out approximately $5.36 billion in settlement awards to compensate survivors of the 2015 Butte, 2017 North Bay, and 2018 Camp Fires. Over the past several months, I have heard from many, many constituents who are concerned that they may owe federal taxes on some or all of their FVT payment.

I wrote(link is external) to the IRS in June of this year, outlining several potential tax issues facing settlement recipients and requesting formal guidance from the agency.

In response, the IRS clarified(link is external) that a number of existing tax provisions may assist taxpayers in deferring or fully offsetting any tax liability arising from FVT payments. These provisions are especially relevant to survivors who have rebuilt or are in the process of rebuilding their homes. I have outlined the applicable provisions below.

However, while the tools described below may help many survivors, I am concerned that current law may still impose a tax burden on many who lost their homes. I am also opposed to the requirement in current law that settlement recipients use the full amount of their award when calculating any tax liability – including the roughly 30 percent paid to attorneys.

That is why I have introduced legislation (H.R. 7305) to fully exclude all proceeds from the trust and all related attorneys’ fees from federal taxation. This is my top priority heading into end-of-year tax policy negotiations, and I am committed to getting this done. No wildfire survivor should be taxed on settlement awards from the Fire Victims Trust.

As I continue working with my colleagues in the House and Senate to enact this legislation, the information below may be helpful to you. As always, please do not hesitate to contact my office.

**NOTE: My staff and I have prepared these materials for general informational purposes only. In line with Congressional Ethics rules, this is not to be taken as formal accounting, tax, legal, or other professional advice, and I encourage you to discuss these matters with a financial advisor, attorney, or CPA. In addition, this IRS website(link is external) describes further guidance on tax relief for survivors of California wildfires.

In addition to the relevant provisions of the tax code, I have also provided a number of generalized examples as to how these provisions might apply.

1. Settlement awards related to personal physical injury: Payments made from the trust to compensate survivors for personal physical injury or physical sickness related to a wildfire should be nontaxable.[1] This also applies to payments made for emotional distress attributable to a relevant physical injury or sickness.

EXAMPLE: Suppose you receive a $500,000 settlement award which includes $50,000 for personal injury and $50,000 for emotional distress attributable to the injury. In this case, $100,000 of the settlement would be non-taxable. The remaining $400,000 may be subject to tax, but the provisions described below may apply to offset or defer any tax liability on the remaining $400,000.

1. Property used as your principal residence: Settlement awards made to compensate survivors for the destruction of part or all of a principal residence are generally non-taxable, so long as the recipient owned and used the property as their principal residence for at least two of the five years before the fire. If you are married and file a joint return with your spouse, the settlement award should be nontaxable up to a $500,000 gain for married couples (or $250,000 for single filers). (Gain here describes the amount of the settlement award minus your adjusted basis in the property).[2]

EXAMPLE:  Suppose you bought your home for $200,000 and made no improvements to it, meaning your basis in the property is $200,000, and suppose you lived in the property as a primary residence for three of the five years before the wildfire.

If you receive a $275,000 award from the FVT, and are married filing jointly, the entire amount of your settlement should be nontaxable – because in this example, you have a $75,000 gain on the property, which is less than the $500,000 exclusion threshold.

However, if you received a $750,000 award from the FVT, you would potentially owe taxes on $50,000 worth of gain, because your $550,000 gain on the property exceeds the $500,000 threshold by $50,000.

1. Using the award to rebuild your home.  If any portion of a settlement award related to the destruction of your property would otherwise be taxable, you may be able to delay taxation of that amount by reinvesting the amount in replacement property. Generally, you must purchase replacement property within two years after the end of the year in which your property was destroyed, or within four years after the end of the year in which your property was destroyed if the property is in a Federally declared disaster area.  You may apply for an extension of this period under procedures described in IRS guidance.[3]

**NOTE: I am in the process of confirming whether individuals who have already rebuilt or replaced their lost property will face a tax burden on settlement awards. Given that these individuals have already rebuilt or replaced their property, it is fundamentally impractical to require that they use settlement funds to rebuild or replace the property destroyed – especially within the described two- or four-year timeframe. I will update this document with additional information as I learn more.

1. Previously claimed casualty loss deduction. Taxpayers whose property was destroyed by wildfire may have claimed a casualty loss deduction prior to receiving a settlement award. In this case, your award would be taxable to whatever extent your casualty loss deduction reduced your taxable income in the year you claimed that deduction.[4]
2. Attorney’s fees.  If a portion of the settlement award that you receive is paid to your attorney, when you are calculating how much of the award may be taxable, you generally must start with the total amount of your award, not reduced by legal fees.

EXAMPLE:  Suppose you receive a $500,000 settlement award, of which $150,000 is paid to your attorney, such that, after payment of the fees, you are left with $350,000.  You generally must start with the $500,000 award, not reduced by the attorney’s fees, in determining how much of the award may be taxable.  In other words, the portion of your award used to pay your attorney’s fees may not be excludible from income, and also may not be deductible.[5]

 

REP. MIKE THOMPSON

 

[1]  The IRS provides specific information about the tax treatment of settlements and judgments on its website, available at https://www.irs.gov/government-entities/tax-implications-of-settlements-and-judgments(link is external).

[2]  The IRS provides frequently asked questions for disaster victims whose main home is in a Federally declared disaster area, available at https://www.irs.gov/businesses/small-businesses-self-employed/faqs-for-disaster-victims#saleofhome(link is external).

[3]  The IRS provides frequently asked questions for disaster victims whose main home is in a Federally declared disaster area, available at https://www.irs.gov/businesses/small-businesses-self-employed/faqs-for-disaster-victims#realizedgainonmainhome(link is external).  For further details, see IRS Publication 547, which discusses gains realized in homes in disaster areas, how to postpone a gain, and how to request an extension of the replacement period on pp. 15-16, available at https://www.irs.gov/pub/irs-pdf/p547.pdf(link is external).

[4]  The IRS provides frequently asked questions for disaster victims who previously claimed a casualty loss deduction and subsequently receive reimbursements for such loss, available at https://www.irs.gov/businesses/small-businesses-self-employed/faqs-for-disaster-victims#amendedreturns(link is external).

[5]  IRS Publication 529, which provides information on Miscellaneous Deductions, discusses legal fees on page 5, which you may find helpful:  https://www.irs.gov/pub/irs-pdf/p529.pdf(link is external).