Proceeds from a lawsuit

[Sabetaytax68]

Own Condo Bylaws provided if upstairs owner changes floor to hard surface from rug and pad notice must be given to downstairs owners affected before Board can approve. This was not done and sound transmission increased 4 fold per sound testing. Floor installed was with inferior soundproofing. Was forced to sue to compel correction or damages for diminished value of my unit and loss of quiet enjoyment. Sued Board, Manager and owner of above unit. After almost two years of litigation during which I incurred over $20K of attorney fees and expert fees, at last minute before trial insurers wanted to settle I wanted flooring and sound proofing of higher sound attenuation  they ultimately agreed to settle for $30800.00 and I paid for flooring change in above unit and remainder was to recover back atty/expert fees and costs which produced net of $ 2000 for loss of quite enjoyment until upgraded flooring installed. No claim for loss of income or personal injuries or medical expenses. If the settling insurers issue a 1099 how do I report this as I do not consider it income which should be taxable. Can I offset cost or floor replacement in above unit and my costs in getting resolution?

[BettieG]

Wow!  This is a great question.  In short, the answer depends upon how your settlement amount was allocated by your settlement agreement and whether and how the Form 1099 reports the proceeds.

Legal settlement payments are generally taxable, including any punitive settlement amount and interest, except for payments made to compensate for physical injury/sickness (and emotional distress or mental anguish if directly related to a physical injury/sickness).  In other words, settlements for non-physical injuries/sicknesses are normally taxable.

Using the IRS guidance, all income from whatever source is included in gross income unless a specific exception exists.  The most common exceptions regarding settlements are those noted above.  You may want to consider this IRS resource to guide you on the tax implications of your settlement:  IRS:  Tax implications of settlements and judgments and IRS:  Settlements -- Taxability. 

In most instances, the attorney’s fees from an otherwise taxable settlement can’t be deducted.  Please see this TurboTax article:  Can I Deduct Legal Fees on My Taxes?

I appreciate that this may not be the answer you were hoping for, but I hope it’s nevertheless helpful to you.

[EleanoreS]

Good day.  I am sorry you had a long path to resolve the sound issue in your condo.

Per the IRS, settlements for the loss in value of property that are less than the adjusted basis of your property are not taxable and generally do not need to be reported on your tax return.  However, you must reduce your basis in the property by the amount of the settlement. IRS Publication 4345 covers all types of settlements and the tax ramifications.

If you believe the settlement falls into the category of loss in value of property and you receive a form 1099, I would suggest that you contact the settling issuers and request that the 1099 be adjusted.

Thank you for joining us at the Ask the Expert event today!

[Sabetaytax68]

Thank you for response. Settlement specified only that I would be paid $30,800, out of which I had to pay about $11,000.00 to take out flooring and inadequate sound proofing installed in unit above me and to install better grade flooring and improved sound proofing limiting sound transmission and continuing diminution of value to my property due to excess sound transmission resulting from change to hard surface flooring without prior required notice to me and the remainder for general damages for loss of use and quiet enjoyment for two years since installation without prior notice to me. In my mind I agreed to settlement because it remedied problem reducing sound transmission, and general damages covered what it had cost me to mostly get back to where I had been before as to level of sound transmission which was about $2000.000 in out of pocket expert fees, court costs and legal fees, with a little (almost nothing for loss of quiet enjoyment) while sound impacts continued until floor and sound proofing replacement. I was not looking to get rich only to be returned to status quo before Rules and Regulations of HOA were breached by changing flooring in upper unity without prior notice to me. Had I been given appropriate notice I would have reviewed proposed changes and insisted upon appropriate sound proofing or would have gone to court to seek a restraining order preventing Board Approval but that was not possible as I did not recieive required advance notice.

I will just wait to late February to see if I get any 1099 from settling parties’ insurance companies but if I do will be seeking Turbo Tax expert help in filing necessary forms so as not to be taxed on recovery which would add insult to past injury.

[Sabetaytax68]

Correction to above costs to get back to status quo before violation of Rules and Regulations for prior notice to were about $20,000 for expert fees, court costs, and attorney fees event though those amounts were not specified in lump sum settlement amount with only amount specified was that I had to pay out of gross settlement about $11,000 directly to contractor to take out flooring originally installed without prior notice and install better grade of flooring with superior soundproofing to remedy continuing general damages and loss of quiet enjoyment.

[Opus 17]

Sorry, you don't get any adjustments for legal fees or other costs, unless this is income-producing property (then you can deduct the fees as a legal expense).

The settlement is not taxable income now, but you reduce your cost basis by $30,800 when you sell, which will reduce your taxable capital gains.  You also can't claim a cost basis increase for the money you paid to improve the upstairs flooring, since those improvments were not made to your property.  

[Sabetaytax68]

Thank you for your response but leaves me a bit confused. If, as you say, settlement is not taxable now then  I do not need adjustments for out of pocket costs to get back to status quo before improper and unsatisfactory installation without notice. The settlement amount was in my mind only cost to remedy the problem (remediation) and general damages for loss of quiet enjoyment. I just wanted the problem done with quiet enjoyment and not being out of pocket to get back to where we were before original change.  The contributing insurers to the settlement just wanted to be done with a suit where a jury could have awarded substantially more in damages for a continuing nuisance caused by excessive sound transmission which was about to go to trial without the flooring being changed which diminished the value and use and enjoyment of my property. If the offending parties, upstairs owner, Building Manager, and HOA Board had remedied the installation, when I discovered the installation then I would never have and never have had to sue in the first place and thought the settlement was not for attorney fees and costs but for general damages only and the cost to change flooring and sound proofing in unit above. How in any real World is that income to me? Which is taxable now or reduces the basis in my property?

[Opus 17]

The problem is, that all income is assumed to be taxable unless there is a legal principle, deduction, or section of the law that says otherwise.   The payment of $30,000 to you could be treated as purely taxable income, with no deductions for legal fees and expenses (because those deductions were eliminated for non-business property for 2018-2025 by the 2017 tax reform law).

However, because this settlement is for loss of value of property that you owned, you can take it as compensation for that loss in value, but that means reducing your basis.  In other words, if the condo cost $200,000, your new basis is $170,000.  That will result in a larger capital gain when and if you sell. But it is still to your advantage to treat it this way, because capital gains are taxed at a lower rate, and future money is cheaper than present money due to inflation.  So paying an extra $4500 in capital gains tax 5 years from now is better than paying an extra $6600 in income tax now.

The settlement is compensation for lost property value.  The fact that you used some of the money to repair the damage (by adding proper sound insulation) would have been an addition to your cost basis had you made the improvement to your unit (maybe by messing with the ceiling?). But because you improved someone else's unit, you can't include that as an adjustment on your cost basis.

(As an example, suppose the power company comes on my property and destroys a mature oak tree to fix a power line, they pay me $5000 in compensation for the lost property value.  I pay $1000 to plant a new tree.  My basis is reduced $5000 by the payment for lost value, and then increased by $1000 since improvements add to the cost basis -- no matter where the money came from.)