another more realistic example

another more realistic example would be that she bought a used car at a super good deal. The Fair Market value of the car is $5000, and she only paid $1000 for it. In this case, if her insurance paid her $5000, she would need to pay tax on the gain of $4000. It is treated as if she sold the car at $5000, and had a gain of $4000.

There is an assumption that the insurance proceeds is considered as return of the basis. However, the assumption is always rebutable.