When you receive a settlement in your personal injury case, you may wonder if any strings are attached to your agreement. Specifically, many victims of personal injury wonder if they have to pay taxes on their settlement and if the funds they receive are truly enough to compensate for their losses. The IRS outlines several rules that you need to know to keep your finances in order following your final settlement.
Physical Injury Compensation
In most personal injury settlements, you will receive compensation for physical injuries or sicknesses. These damages mainly cover medical expenses, such as doctor’s visits, medications, surgeries, hospitalization costs, and physical therapies. The IRS has two rules when it comes to filing your taxes after you have received physical injury compensation.
The two rules depend on whether you deducted medical expenses from your taxes prior to receiving your settlement. It can take a very long time for you to receive this compensation – personal injury lawsuits can take a year or more to settle. As a result, many victims can claim these medical expenses to help save money on taxes.
If you did not deduct medical expenses related to your injury before you received your settlement, your full compensation is non-taxable and you do not include your settlement on your income. If you did deduct medical expenses in the past, you will have to include the same amount you deducted as income.
Emotional Distress and Anguish Settlements
You may also receive compensation for emotional distress due to your physical injury. These funds help you cope with certain noneconomic damages, such as mental anguish, pain and suffering, disability, loss of quality of life, and post-traumatic stress disorder. If you received compensation for emotional distress as a result of the physical injury, you will follow the same tax rules as for physical injury compensation.
However, if the compensation you received for emotional distress did not originate due to a physical injury or illness, you have to include these funds in your income. You can reduce the amount you have to report by the medical expenses you paid for the emotional distress you did not already deduct. You can also reduce this amount by the medical expenses you previously deducted that did not give you a tax benefit.
If you file a lawsuit and receive funds for the loss of your property, you will need to examine if your adjusted basis of property is higher or lower than the settlement amount. If the basis of property is higher than your compensation, you do not have to report the funds on your taxes – however, you need to reduce your basis in the property by your settlement amount. If your settlement exceeds your basis in property, you will need to report the excess amount as income.
Other Forms of Compensation
You may receive punitive damages, which courts award in situations where the negligence that caused your injury was especially egregious or reckless. The purpose of punitive damages is to punish the at-fault party, rather than compensate you for your losses. As a result, punitive damages are a form of taxable income by the IRS. You must report any punitive damages on your tax return, even if you received them in a physical injury lawsuit.
You may also receive interest on your settlement payments from the at-fault party. If you receive interest payments, you have to report them as income, and it is taxable. In addition, you may have to pay taxes on a settlement if your case involves a breach of contract. If a breach of contract causes your injury and you use the breach as the basis of your lawsuit, you will need to report your physical injury compensation as taxable income.
If you need help determining which portions of your settlement are taxable and which are tax-exempt, contact an El Cajon or La Mesa personal injury attorney as soon as possible. Your attorney can help answer any questions and refer you to a trusted tax professional.