Everything was arranged. The replacement property was under contract, the loan was approved, the closing was three weeks out and comfortably inside the window.
Then a hail storm took most of the roof.
A casualty between contract and closing is three problems wearing one coat: a contract question, an insurance question, and a deadline question. The first two can be worked through. The third does not wait for either.
Which side it lands on changes everything
Damage to the property you are selling threatens the start of the exchange. Your buyer may have the right to terminate or to demand a credit, and if they walk, there is no sale, no proceeds, and no exchange to speak of. Insurance proceeds for the damage generally belong to whoever owned the property when the loss occurred, which is you, and money received that way is not sale proceeds. It is a separate tax event that may fall under the involuntary conversion rules we describe in 1033 exchanges, which is a different regime with different timing from Section 1031.
Damage to the property you are buying threatens the end of it. Lenders will not fund against a damaged building, the seller may need months to repair, and the insurance adjustment runs on the carrier's schedule. Your 180 days run on nobody's.
| Relinquished property damaged | Replacement property damaged | |
|---|---|---|
| Immediate risk | Buyer walks, sale collapses | Lender will not fund |
| Who holds the claim | Generally you, as owner at the loss | Generally the seller |
| Effect on the exchange | It may never start | It may not finish in time |
| Tax angle | Possibly an involuntary conversion | Mostly a timing problem |
Read the risk of loss clause now, not then
Who bears the risk between contract and closing is set by the purchase agreement and, where the contract is silent, by state law. Several states have adopted a uniform act that allocates it, and the allocation is not the same everywhere.
What a well-drafted contract adds is thresholds. Below some level of damage the deal proceeds with a credit or an assignment of the insurance proceeds. Above it, either party may terminate. Negotiating that number before anything happens is straightforward. Negotiating it afterwards, with a deadline approaching, is not.
Also confirm, in writing and early, that the policy is in force, who is named on it, and whether the lender is a loss payee. A casualty is the wrong moment to discover a coverage gap, which is the same discipline we set out in binding insurance.
What to actually do in the first week after
- Tell your intermediary and your attorney immediately, because the options narrow quickly and some of them depend on the contract.
- Decide whether the deal still works at a credit, with repairs, or not at all. Sentiment is expensive here.
- Price the repair properly rather than accepting the seller's estimate or the adjuster's first number.
- Check your remaining days honestly. A repair that takes ten weeks when you have eight is not a plan.
- Activate a backup. This is the situation the three-property rule exists for, and you can still revoke and re-identify if you are inside day 45.
The uncomfortable truth is that a casualty often forces a choice between the property you wanted and the deferral you were protecting. Deciding which matters more, quickly and unsentimentally, is usually what separates a bad outcome from a very bad one. Your attorney advises on the contract and your CPA on any insurance proceeds you receive.
Common questions about casualty before closing
Who bears the risk if the property is damaged before closing?
The purchase agreement decides, and where it is silent state law allocates it. Several states have adopted a uniform act, and the result is not the same everywhere.
Who gets the insurance proceeds?
Generally the owner at the time of the loss, unless the contract assigns them. Make that explicit rather than leaving it to argument.
Does a casualty extend my 180 days?
No. Deadline relief comes from federally declared disasters through specific IRS notices, not from damage on its own.
Are insurance proceeds I receive part of my sale proceeds?
Generally no. They are a separate item and may fall under the involuntary conversion rules, which have their own timing. Ask your CPA.
What should the contract say?
A risk of loss clause with damage thresholds: below a stated level the deal proceeds with a credit or assigned proceeds, above it either party may terminate.
Disclosure: Numerical example is for illustration purposes only; individual circumstances will vary.