Final answer:
Mary must report the $5,000 insurance payout as income on her 2013 tax return due to the tax benefit rule, since she took a casualty loss deduction in 2012. The amount to be included as income depends on the calculated adjustment of her previous deduction, and she may potentially have a taxable gain if the recovery exceeds her adjusted deduction.
Step-by-step explanation:
The proper tax treatment of the $5,000 Mary received from the insurance company in 2013 after previously taking a casualty loss for the stolen ring on her 2012 tax return would be to include this amount as income on her 2013 tax return. This is because the insurance recovery represents a reimbursement for a loss she had claimed as a deduction in the previous year. According to the tax benefit rule, if you receive a reimbursement in a later year for a deduction taken in an earlier year, you must include the reimbursement to the extent the deduction reduced your tax in the year of the deduction.
Mary must calculate if any part of the recovery must be included in her gross income. This would depend on the amount she deducted as a casualty loss, adjusted by any salvage value and insurance proceeds. If the insurance payout in 2013 is less than or equal to the adjusted deduction she took in 2012, she must report the recovery up to the amount of the deduction that reduced her taxable income. If the insurance payout exceeds the adjusted deduction, she may be reporting a recovery amount that could potentially result in a taxable gain because she would have received more than the value of the loss she previously deducted.