Taxes on a Court Settlement

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If you receive a payment as the result of a lawsuit, you might owe taxes on the settlement amount. Whether or not you owe depends on the type of settlement and how the payment is classified. You may owe taxes on portions of a settlement, while other portions are tax free. Consult a tax professional to determine the exact taxes you owe.

Physical Injury and Emotional Distress

If you receive a settlement because of an injury or illness you suffered, the Internal Revenue Service doesn’t consider the amount you receive as taxable. However, if you deducted medical expenses from your taxes that were related to the illness or injury that prompted the lawsuit, you must claim the amount equal to those previously deducted medical expenses as income on your tax return. While damages awarded for emotional distress are normally taxable, if the emotional distress is due to a physical injury or illness, the damages might not be taxable, attorney Robert Wood said in a 2012 issue of "Forbes" magazine.

Lost Wages or Income and Interest

If you sue for lost wages or loss of income and win a settlement, the proceeds from the settlement are taxed as ordinary income. If your settlement includes interest payments, report these as you would other taxable interest on Form 1040.

Property Damages and Punitive Damages

If you receive a settlement because of property damage, only the portion of the settlement that exceeds the adjusted basis of the property that was lost or damaged is taxable. The adjusted basis of the property is the cost plus any improvements you made, minus any deductions, such as depreciation. The IRS considers all punitive damages you receive in a settlement to be taxable income.

Reporting Settlements

If you receive a settlement, you should receive a Form 1099-Misc the following January that shows any taxable amounts you were paid. If you were awarded back wages, you’ll receive a W-2 form showing these wages. Report back wages on Line 7 of Form 1040, where you report wages, salary and tips. Report interest on Line 8A. Report other proceeds from a settlement on Line 21, which covers other income.