Ever wondered what happens when you get money for your property from the government or another organization? If you’ve received a payment based on the fair market value of your property, often called a fair market value award, you might be asking, “How is this taxed?” In this guide, we break down how the fair market value award tax works, what you need to watch for, and how to plan for tax time.

What Is a Fair Market Value Award?

A fair market value award is money you receive when your property is taken, usually by the government, through a process called eminent domain. This means the government needs your land for a road, school, or other public project, and pays you what your property is worth on the open market. The amount you get is meant to be fair, so you’re not left worse off. But even though it feels like you’re just getting paid what you lost, the IRS still considers this a taxable event.

Is the Fair Market Value Award Taxable?

The short answer is yes, in most cases, the fair market value award is taxable. The IRS sees this payment as a sale, not a gift. When your property is taken and you receive a fair market value payment, the difference between what you paid for the property (your tax basis) and what you receive is generally taxable. This is true whether you’re a homeowner or a business owner.

Here’s what usually happens:

  1. You figure out your tax basis. This is what you originally paid for the property, plus certain improvements.
  2. You subtract your basis from the payment you received.
  3. The result is your gain, which may be taxed as a capital gain.

If your property has gone up in value since you bought it, you could owe capital gains tax on the difference. If it went down, you might have a loss, which has its own tax rules.

How Is the Principal Award Taxed?

The main part of the payment, the principal award, is usually taxed as a capital gain. Capital gains tax is the tax you pay on the profit from selling property or investments. If you owned your property for more than a year, it’s considered a long-term capital gain, which is often taxed at a lower rate than short-term gains.

But there’s a catch. If you receive extra payments, like for lost business income, relocation costs, or interest, those might be taxed differently. For example, interest paid on top of the main award is taxed as ordinary income, not as a capital gain. So it’s important to know what each part of your payment covers.

Are There Ways to Reduce or Delay Taxes?

Yes, there are ways to reduce or delay taxes on a fair market value award. One common option is called a “like-kind exchange.” This lets you use the money from your property award to buy another similar property, allowing you to defer paying taxes until you sell the new property. But you have to follow strict IRS rules to qualify.

Another way is to make sure you’re only taxed on your actual gain, not on what you spent to improve your property or on money you have to use for things like moving. Keeping good records and getting help from a tax professional can save you money.

What About State Taxes on Property Value Payments?

Federal tax is only part of the story. Many states also tax fair market value awards. Some states follow the IRS rules closely, while others have their own twists. You might face state capital gains tax, or different rules for how principal award tax is calculated. Always check your state tax rules or talk to a local expert.

Common Situations and Questions

What if I have a mortgage on my property?

If you still owe money on your property, the fair market value award may first go to pay off your mortgage. You’re only taxed on the gain after the mortgage is paid.

Do I have to report the payment if I reinvest it?

Even if you reinvest using a like-kind exchange, you still need to report the transaction. The IRS wants to know what happened, even if taxes are delayed.

Is a payment for business property taxed differently?

Business and personal property are taxed in similar ways, but some special rules may apply if your property is used for business. A tax advisor can help you sort out the details.

Key Takeaways

The fair market value award tax can be confusing, but it usually works like a sale for tax purposes. You’ll likely owe taxes on the gain, but there are ways to reduce or delay what you owe if you plan ahead. Keeping good records and getting expert advice can make a big difference. Contact us to learn more.