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What is the the IRS's view on insurance payment for a car that was deemed a total loss? Is the state tax for each state in this scenario the same? Or, do different states have different approaches? Any ideas about MA tax in this case?

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DJClayworth's response is generally correct. You wouldn't have to pay taxes on insurance benefits, since those are in fact bringing you whole to what you've lost.

However, in some cases you do need to consider taxes. Specifically, if the insurance payout is higher than your cost basis in the lost property. While you may think that this never happens (why would the insurance company pay more than what it cost you?), it in fact quite frequently does.

Specific example would be a car used in your business. If you used your car as part of your business and deducted car depreciation on your tax return - your cost basis was reduced by the depreciation. Getting a full car cost payout form insurance would in fact constitute taxable income to you for the difference between your cost basis (adjusted for the depreciation) and the payout.

Another example would be collectibles. Say you bought a car 20 years ago at $5000, you maintained it well during the years (assume you spend another $5000 on repairs), and it is now insured at FMV of $50000. But, alas, it got destroyed by a mountain lion who climbed over the fence and pushed it over a cliff. You got a $50000 payout from your insurance company (because you insured it for full FMV coverage, as a collectible should be insured), of which $40000 will be taxable to you.

There may be more specific cases where insurance payouts are (partially) taxable. However, as a general rule, they're not, as long as they're at or below your cost basis level.

  • That is a good point. But how the IRS/state can know how much I paid for it and how much I was paid out for it? What about when a car is bought below market price and the insurance pays more than what it was purchased for (not exactly your FMV example...)? – KingsInnerSoul May 18 '14 at 16:57
  • @KingsInnerSoul well, if the IRS/State audits you - they'll ask you to show the documentation. If you cannot - they'll claim that the whole payment is taxable. – littleadv May 18 '14 at 22:04
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Generally you do not pay taxes on insurance payouts that occur because of some kind of loss, provided you paid the premiums yourself.

"Generally, if you're paying premiums yourself, such as for homeowners insurance and auto insurance, then your insurance benefits are not a taxable event," says Adam Sherman, CEO of Firstrust Financial Resources in Philadelphia. "Your benefits are reimbursement for expenses, rather than income."

It's not as straightforward for death benefits and life insurance.

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    This is assuming your benefits aren't higher than the cost basis, of course. – littleadv May 18 '14 at 7:54
  • A good point. I bow to your superior answer. – DJClayworth May 20 '14 at 2:19

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