Even though there’s almost four months until tax returns are due, it’s officially tax season. And for those chasing a refund from the IRS, you can beat the crowds and get your return processed now. According to the IRS, 40% of all tax return are filed before the end of February. So for you early filers, we are writing to address a common concern among people who have collected money through a personal injury settlement or judgement during the tax year. That concern is whether that money should be taxed as income by the IRS. The answer…it depends.
Generally, if you are being compensated for a physical or emotional injury then those proceeds are not considered income, and thus, not taxable. However, if the settlement includes compensation for lost wages, back pay or lost profits from a trade or business then the settlement or judgment must be reported on line 7 of your 1040. For example, the most common example of this is someone who is injured and is unable to work for certain period of time. Say you make $1000 a week and miss one week of work. You then receive a payment of $1000 in your personal injury settlement. You must now claim that $1000 as income on your 1040.
Another area to be aware of is the collection of medical bills. Generally, if you’ve incurred medical expenses in a settlement or judgment then you don’t have to claim the bills as income. However, if you receive reimbursement for medical bills that you previously deducted on a prior years tax return then you must include as income the medical bills that you previously deducted. This situation is rare as Oregon mandates PIP coverage so most of the medical bills are paid by your insurer within the first year. But if you are involved in a personal injury claim and you’ve paid medical bills out of pocket, be diligent about whether you’ve deducted those medical bills from taxes in prior years.
The treatment of property damage settlements is probably the most confusing when it comes to tax consequences, but are relevant since personal injury claims often involve claims for property damage or diminished value. The general rule is that payment for loss of value to your property is not taxable so long as the payment does not exceed your adjusted basis in the property. I’m not going to get into what adjusted basis is because it exceeds the scope of this blog. However the consequences of receiving a payment for property above your adjusted basis is it creates capital gains.
As you can see from the various rules it’s important to clearly indicate what the settlement or judgement is for. While personal injury attorneys are often times familiar with the tax consequences of settlements, you should still seek the advice of a CPA in complicated settlement scenarios. Clearly itemizing the settlement will help you, your lawyer and your accountant to accurately assess you tax liability as a result of a settlement or judgment.