Dear Tax Talk:
I am about to receive a settlement from our home builder for defects to our home. Will there be any tax liabilities from this settlement?
To determine if a settlement is income, you have to look at what the settlement is intended to replace. In a settlement, as opposed to a judgment, the origin of the claim determines the taxability of the payment. Since your claim involves defects to your home, the compensation is intended to make you whole in the home purchase. The payment would be considered a reduction to the cost of your home. Any defects that you repair would add to the adjusted basis of your home. This is true whether the repairs are made before or after you receive the settlement proceeds.
If you do not make any repairs or the repairs cost less than the settlement, you do not have a taxable gain. You would only have a taxable gain if the settlement exceeds the cost of the home. Any interest or punitive damages associated with the settlement would be considered income in the year received.