Generally,
1. If you use some of the settlement money for repairs, it is not taxable income but it does not increase your cost basis. A repair is something that keeps the property in as condition. Fixing a hole in the roof without replacing the entire roof would be a repair.
2. If you use some of the settlement to make improvements, that is not taxable and it increases the cost basis of your home. An improvement extends the life of the property or adds value to the property, makes the property better. Remediating mold damage or replacing all the wiring with modern wiring would be an improvement. Increasing the cost basis of your home may result in lower capital gains tax when you sell.
3. If some of the settlement is compensation for hidden lost value (the home was worth less than you thought due to seller misconduct), that money is not taxable either. However, it reduces your cost basis.
So, putting that all together, let's suppose you paid $100,000, and due to concealed damage you received a settlement of $30,000. And you make $25,000 of improvements to restore the property. Your cost basis for the home will now be $95,000.
4. However, there is a complicating factor. If some of the settlement is punitive damages, that is, punishment to the real estate agent or seller for lying and not compensation for loss of value, then those punitive damages are taxable income (and they don't adjust your cost basis one way or the other).
It may not always be clear whether part of the settlement includes punitive damages. This is something you might want to discuss with your attorney.
However you decide to allocate costs, keep excellent records of your financial decisions, how you determined the loss of value, and your repair costs. And keep these records for at least seven years and preferably for at least seven years after you sell the house. You will need these records if you are audited to show the IRS how you determined the allocation of the settlement.
