There has been much heated debate over the federal taxation of this. CA residents and politicians are working hard to make this exempt. Rather than summarize where they are on this, I would prefer to refer you to this site: https://calfiretaxinfo.org/latest-news/
which seems to be tracking this carefully.
You could file your federal and state tax return an NOT report this, but be aware the IRS could send you a notice saying you have unreported income. (if it ended up being taxable).
Alternatively, you could report it as income, and then try to claim a refund by amending your return, if it turns out to not be taxable.
My personal preference would be to not report it as income at federal level, but be prepared to send in the tax due, if it turns out to be taxable. With this approach, you wouldn't be troubled to file an amended return to get your overpaid tax. Others on the team might have a different take on this, and are welcome to weigh in.
Good luck to you,
Kelly C,
CPA
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