Burned lots in L.A. will sit empty for decades unless Congress tweaks the tax code

In the coming weeks, Congress will write tax and spending legislation that should include relief for many victims of the Palisades and Eaton fires. But apart from the cash assistance Gov. Gavin Newsom has already requested, California’s congressional delegation should work to include two urgently needed changes to the tax code in that same legislation. Without these, rebuilding the fire-ravaged areas of Los Angeles could take years longer.

The Internal Revenue Code was not written with massive urban wildfires in mind. By taxing the revenue from most sales as income, current tax law encourages many fire victims to hold their now-empty lots until death to avoid a huge tax bill. The tax code also discourages potential buyers from purchasing empty lots and building new homes because they could be penalized for selling their current homes. These perverse incentives will dramatically slow the process of rebuilding. The way to fix this is to change the way the tax law applies in presidentially declared disaster areas.

Our California delegation in Washington should find a receptive audience in Congress for this discrete reform, because getting fire-gutted communities back on their feet isn’t just an act of mercy. It’s essential to restoring the tax base, for both state and federal revenue.

For the first reform, Congress should exempt victims in presidentially declared fire disaster areas from income taxes resulting from the receipt of insurance proceeds and the sale of their lots.

Second, to incentivize buyers in the fire areas, Congress should allow deferral of income taxes on the sale of a principal residence, if the sale proceeds are used to buy or build a new principal residence in the fire areas.

In Pacific Palisades, where property values have skyrocketed over the last several decades, scores of homeowners had owned their properties for more than 20 years at the time of the fires. Even before disaster struck, these residents — many of them elderly — had a powerful incentive to retain their property until death. By doing so, they could forever avoid income taxes on the appreciation of their homes.

After the fires, that incentive remains. But its effect has changed dramatically now that people have been forced out of their homes. Previously, people staying in their own homes presented no particular problems for them or their communities. Now, people evacuating their burned-out lots, but continuing to hold onto them in that condition until death, creates a big problem. It is the worst possible outcome for the communities — original residents not rebuilding and returning, and new residents not being given opportunities to build and move in.

The tax bill that fire victims would face if they sell is one they might never have had to pay, but for the disaster. And it is not only a product of their property’s appreciation over time. Insurance complicates the picture further.

Under current law, property insurance proceeds reinvested in a new home are generally tax free, but proceeds not so reinvested are subject to tax. Fire victims who sell their burned homes and downsize or relocate to a less expensive area would therefore face a tax double-whammy.

An elderly couple whose children have long since moved away would most likely have no interest in rebuilding — especially given the many years it may take to complete construction. For them, selling and downsizing makes the most practical sense. But not after taxes are taken into account. If they receive a big payout from their homeowner’s insurance but don’t devote all of it to a new home, and they sell their original property for a large sum, they could face a staggering income tax bill, easily $1 million or more. To many, this feels like an insult, coming on the heels of being forced out of their home and seeing nearly everything they once owned go up in smoke.

Unfortunately, the simplest way for fire victims to avoid this financial predicament is to hold their blackened lots until death while moving on to buy elsewhere. So long as they reinvest 100% of any insurance proceeds in a new home elsewhere, they can completely avoid these taxes. At the same time, they can borrow against the value of their lot to generate tax-free cash, using those funds to supplement the cost of a smaller home and help pay their living expenses. Great for them, perhaps, but bad for Southern California and its tax base.

The other part of the tax code to be addressed concerns buyers in the fire areas. For decades, the tax rule was that buyers purchasing a new principal residence for an amount greater than the sales price of their prior residence could defer any income tax from the move. But since 1997, the benefit of that provision has been capped at $250,000 ($500,000 if married). Inflation has further reduced its value: $250,000 in 1997 equates to just $125,000 today. Restoring the pre-1997 rule for buyers in the fire areas will ensure there are buyers as well as sellers. That will invigorate the market for reinvestment in these shattered communities.

These two reforms amount to simple justice. Fire victims shouldn’t be hit with income taxes that would never have been owed otherwise. The tax code shouldn’t incentivize them to hold fire-damaged lots for the rest of their lives, at the expense of the surrounding communities. Putting in place the right tax incentives for both buyers and sellers will get Altadena, Malibu and Pacific Palisades built back faster and better. And this in turn will regenerate tax revenue for the benefit of Californians and all American taxpayers.

Christopher Cox is a senior scholar in residence at UC Irvine and a former chairman of the U.S. House Homeland Security Committee. Hank Adler is a professor of accounting at Chapman University.