Dear Tax Talk,
I paid $65,000 for my home. I have a sinkhole and received $200,000 from the insurance company. I'm not fixing the home, but I'm going to sell it. I will probably only get about $20,000 for the home. I am going to use about $30,000 to buy another home that I already own half of. Do I have to pay taxes on the difference between the $200,000 and the $45,000 ($65,000 paid for home minus $20,000 I'll sell it for)? If so, is it ordinary income or capital gains? I am getting the insurance money in 2010 but won't be able to sell the home until 2011, if that matters.
-Kristine

Dear Kristine,
I think you've redefined the term "money pit." What happened must have been a disaster, but at least you won't have to worry about tax problems. The insurance settlement and subsequent sale are treated as the sale of your home. Even though you do not reinvest the proceeds in a new home, you can exclude the capital gain on the sale as if you had sold your home. An individual is entitled to exclude up to $250,000 in gain from the sale of their home if they have owned and lived it in it for more than two years within the last five years.

Considering the amount of appreciation in your home, I assume you have lived in it longer than the requisite two years. If you don't meet the two-year criterion, there are exclusion rules that could apply to get you a good part of the exclusion such as those rules under unforeseen circumstances.

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