Do You Have to Report Settlement Money on Your Taxes?

Understanding the tax implications of settlement money is important. The taxability of settlement money depends on the nature of the claim and what the settlement is intended to compensate. The Internal Revenue Service (IRS) considers all income taxable unless a specific exception is provided by law, as outlined in Internal Revenue Code (IRC) Section 61. The specific reason for receiving the funds dictates whether they are subject to taxation.

Settlements for Personal Physical Injuries and Sickness

Settlement amounts received for personal physical injuries or physical sickness are excluded from gross income. This exclusion applies to damages received whether through a lawsuit or a settlement agreement. For tax purposes, “physical injury” or “physical sickness” refers to observable bodily harm, such as bruising, cuts, swelling, or bleeding. Internal Revenue Code (IRC) Section 104 states that gross income does not include damages received on account of personal physical injuries or physical sickness.

Compensation for medical expenses related to these physical injuries is also non-taxable. If you receive a settlement for physical injuries or sickness and did not deduct related medical expenses in prior years, the entire amount is non-taxable. However, if you previously itemized and deducted medical expenses related to the injury, any portion of the settlement that reimburses those previously deducted expenses must be included in your income to the extent the deduction provided a tax benefit. This is due to the tax benefit rule, and such amounts should be reported as “Other Income” on Form 1040, Schedule 1.

Settlements for Emotional Distress and Non-Physical Injuries

Emotional distress damages are taxable unless they are directly linked to a personal physical injury or physical sickness. The IRS differentiates between emotional distress that stems from physical injury and emotional distress that does not. For instance, if emotional distress or mental anguish is directly attributable to a physical injury, such as anxiety resulting from a car accident, the compensation for that emotional distress is treated the same as the physical injury compensation and is non-taxable.

However, if emotional distress or mental anguish arises from a non-physical injury, such as defamation, discrimination, or wrongful termination where no physical harm occurred, the settlement for such emotional distress is taxable. This distinction is important because only damages received on account of physical injuries or sickness are excludable from gross income. Emotional distress not stemming from a physical injury is considered taxable income.

Settlements for Lost Wages and Business Income

Any portion of a settlement received as compensation for lost wages, lost profits, or other forms of lost income is considered taxable income. This is because these amounts would have been taxable if they had been earned in the normal course of employment or business operations. For example, back pay, front pay, or severance received in an employment dispute are considered taxable wages subject to income tax, Social Security, and Medicare taxes.

These types of settlement proceeds are reported on different tax forms depending on the payor. If the settlement is from an employer for lost wages, it may be reported on Form W-2. If the payment is from another payor, such as for lost business income, it might be reported on Form 1099-MISC. Compensation for income that would have been taxable if earned normally remains taxable when received as part of a settlement.

Settlements for Property Damage

Settlements received for damage to property, such as real estate or vehicles, are non-taxable up to the adjusted basis of the damaged property. The adjusted basis represents your cost in the property, adjusted for improvements or depreciation. If the settlement amount is less than or equal to your adjusted basis in the damaged property, the funds are considered a return of capital and are not taxable.

However, you must reduce your basis in the property by the amount of the settlement received. If the settlement exceeds your adjusted basis in the property, the excess amount is considered a taxable gain. For instance, if property with an adjusted basis of $10,000 is damaged and you receive a $12,000 settlement, the first $10,000 is non-taxable, but the additional $2,000 is a taxable gain. This gain may be reported on Form 1040, Schedule D.

Punitive Damages and Interest in Settlements

Punitive damages are fully taxable, regardless of the nature of the underlying claim. This holds true even if the primary settlement for a physical injury is non-taxable. Punitive damages punish the wrongdoer rather than compensate the injured party for losses, which is why the IRS considers them taxable income. These amounts are reported as “Other Income” on Form 1040, Schedule 1.

Similarly, any interest received on a settlement amount is also fully taxable. This includes interest accrued from the date of the injury or claim until the settlement is paid. The IRS views interest as compensation for the delay in receiving the funds, making it a form of taxable income, regardless of whether other parts of the settlement are tax-exempt.