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Taxes on property damage/medical settlement

George SaenzDear Tax Talk,
We live in and own a home jointly with my in-laws. When a development was put in next to and behind our home, the house sustained damage due to the vibrations during the grading phase. In addition, my mother-in-law had a stroke -- attributed to the vibrations.

We settled with the grading company for $20,000.

The settlement released the company from all liability and specific damages were not named. The check was in the names of all four of us (my husband, myself and my in-laws). We will be dividing up the money among ourselves based on the relative damage to each side of the home, taking into consideration what my mother-in-law suffered, so we will not be dividing it up equally among ourselves. Is the entire settlement taxable, and how much does each couple claim as income for tax purposes?

Look forward to your reply. Your archives are very useful and I appreciate your service to the public.
-- Pua

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Dear Pua,
Thanks for the compliment, and I'm glad to hear that you've browsed the archives. But always remember that the tax laws are changing and that the answers in archived articles are not updated for law changes.

The taxation of settlements is based on the claim that led to the settlement. Presumably, in order to receive the settlement, you or your attorney had to make a claim with the grading company. If the claim specified that you were seeking compensation for damage sustained by your home, then the settlement is considered to be for property damage.

A settlement for property damage is generally not taxable, but instead would reduce your cost basis of the property. For example, in your case, let's assume your house cost you $200,000. Since the $20,000 you received does not exceed your cost, you did not have a gain, so the cost of your property is reduced to $180,000. Presumably, you will have to make repairs to the home to repair the damage caused by the development next door. These repairs will be added to your cost, but it does not change your tax situation if you do not spend the full $20,000.

If your claim to the grading company sought compensation for the stroke your mother-in-law sustained, then the part that you allocate to her for compensation would not be taxable to her and would not reduce your cost or their cost in the home. Compensation for physical injuries is never taxable. For example, assume you give your mother-in-law $5,000 for her suffering, then you would only reduce the cost in the home by $15,000, and the additional $5,000 would be without tax consequence to her.

If somehow the settlement exceeded your cost in the property, then you would need to consult a tax adviser.

-- Posted: May 12, 2005





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