There is a potential tax issue.
You may receive a 1099 form from the builder if they paid you a partial settlement for the cost of repairing the problem. This is not taxable income (unless the payment was more than the amount of the loss), but it may trigger the IRS to send you a letter requesting an explanation.
if you received a 1099 form there are two ways to handle it.
1. enter it on your tax return as miscellaneous income. Then, go to the “other uncommon income“ section and create another item of miscellaneous income with a negative dollar amount offsetting the 1099. Give it a reason like “non-taxable property value adjustment“. This way the IRS sees that you have reported the 1099 and they will see the reason why you did not consider it to be taxable. However, they may still send you a letter asking for more details.
2. or, leave the 1099 off of your return entirely. Print your return and file by mail instead of e-filing. Attach a copy of the 1099 and a brief letter of explanation. Don’t send additional proof of the damage, but keep records for as long as you on the home +3 years after you sell.
In either case, the amount that you pay to improve your property is added to your cost basis and may reduce your capital gains when you sell in the future, but it’s not deductible today. If part of the loss was compensated by a non-taxable settlement, you don’t include that part of the cost of repairs in your cost basis. In other words, if the cost of repairs was $160,000 and you received a $50,000 settlement from the builder, you would include $110,000 as an adjustment to your cost basis.
