Suppose a house burns down, and the insurance company agrees to pay for it to be rebuilt. If the owner dies half way through the rebuilding process, what is the value of the home for estate tax purposes? In a recent case, the IRS argued that the future value of the home when completed should be included in the estate, but the Tax Court disagreed. Here are the facts of the case:

Mary Bull owned a California residence that was destroyed by fire. Her insurance policy covered replacement costs, but only up to 50% of the policy's coverage limits. Still, the insurer agreed to reimburse Mary for the entire cost of restoring the home.

In the summer of 1993, Mary hired a contractor to rebuild the house for $1.27 million, and construction began in 1994. By the time of Mary's death in November of 1994, the insurance provider had paid her more than $1.6 million, including living expenses in addition the cost of rebuilding the residence. At that point, the contractor estimated that he would still need more than $757 thousand dollars to complete the project, for a total cost of more than $1.6 million. The home was finally completed in 1997 for more than $1.7 million. The total of payments received by Mary and by her estate from the insurer was more than $2.8 million, but after its completion, the home sold for only slightly more than $1 million.

The estate reported the taxable value of the residence (which was 57% complete at the time of Mary's death) at $612,000. The IRS, however, determined that the gross estate should include the value of the completed residence.

The Tax Court disagreed, stating that "the asset available for distribution to the beneficiaries was the 57-percent completed residence. The beneficiaries had the option to complete the residence and thereby incur benefits and burdens of such action. The fair market value of the asset received by the beneficiaries, however, was no more or less than the $612,000 fair market value of the incomplete residence." Since the insurer was under no legal obligation to pay for the total cost of rebuilding the residence, the Tax Court dismissed arguments made by the IRS that the value of the residence should be related to amounts paid by the insurer.