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I think reduction of basis for $400 is the correct way. The insurance company pays to repair the roof, it is not an improvement. I understand why this situation takes us off guard. A lot of questions on the EA exams mention that replacing the roof is a capital improvement and must be depreciated. Think for a moment that the insurance paid $4,900 because you house was flooded and you spent that amount of money cleaning and mold treatment. In the flood event, no one will think about capitalizing it.

>>what would be your approach to properly record this transaction<< A net basis reduction of $400.

>>would I include income or gain of $ 4,900.00, yes only in circumstance where taxpayer might have got money from insurance company and pocketed without spending for repairs.<< Here is how the IRS says to figure gain, on page 10 of Pub 547 at http://www.irs.gov/pub/irs-pdf/p547.pdf. "The amount you receive [insurance], minus your adjusted basis." Where does it say anything about repairs? In other words, insurance is treated as a basis adjustment, and ONLY counts as income after basis is reduced to zero. Then, money spent (if any) on repairs or replacement, whether from insurance or any other source, adds back new basis.