Ever wondered why you might owe taxes on some parts of an eminent domain payment but not others? Understanding the tax difference between severance damages vs award interest can save you from a nasty surprise at tax time. If your property is taken, or part of it is, you might hear both terms tossed around. But what do they really mean, and how do they affect your taxes? Let’s break it down so you know what to expect and how to plan.

What Are Severance Damages?

Severance damages come into play when only part of your property is taken for a public project, like a new road or utility line. If the government takes a piece of your land but leaves the rest, that leftover piece might lose value. Severance damages are meant to make up for this loss.

Imagine your backyard is split in half for a new highway. The part left behind can’t be used the same way anymore, so it’s worth less. Severance damages are the money you get to cover that lost value. It’s not payment for the land taken, it’s compensation for how the taking affects what remains.

Severance damages can also apply to commercial properties. Suppose you own a small shopping center, and the city claims the front parking area for a new utility easement. The shops now have less parking, so fewer customers come by. Not only is the parking lot smaller, but the value of your remaining property drops because its use is limited. The payment you get for that drop in value is called severance damages.

It’s important to know that severance damages are separate from the payment you get for the actual land or building taken. The law recognizes that when only part of your property is taken, the impact on what’s left can be significant. Severance damages help make you whole by compensating for that indirect loss.

What Is Award Interest?

Award interest is a bit different. Sometimes, there’s a delay between when the government takes your property and when you actually get paid. Award interest is the extra money paid to you for waiting. Think of it as compensation for not having access to your money during that waiting period.

If your payment is held up for months or even years, award interest is meant to make things fair. The longer you wait, the more interest you get. But while this sounds like a bonus, it comes with a catch, especially when it comes to taxes.

Award interest can add up quickly in drawn-out cases. For example, if the city takes your land today but the payment is tied up in court for two years, you might receive several thousand dollars in interest by the time the case is settled. This interest is meant to cover the lost opportunity to use or invest the money during the delay. It’s not meant as extra compensation for your property, just for your time.

Severance Damages Vs Award Interest: The Core Tax Difference

Here’s where the two start to really diverge. The main difference between severance damages vs award interest is how the IRS treats them at tax time.

Severance damages are generally considered a payment for the loss of property value. In most cases, you won’t owe income tax on the full amount. Instead, you may only pay tax if the damages exceed your original investment in the property. For many homeowners, that means little or no immediate tax bill.

Let’s say you bought your home for $150,000 and later receive $30,000 in severance damages. If you haven’t yet recovered your initial investment (also called your “basis”), you don’t have to pay taxes on the $30,000 right away. Instead, your basis is reduced by the amount received. You only have a taxable gain if your total compensation ends up higher than your basis.

Award interest, on the other hand, is treated as regular income, just like the interest you’d earn from a savings account. No matter how much you invested in your property, you’ll owe taxes on the full amount of award interest. This can lead to a bigger tax bill than you expect if you’re not prepared.

Unlike severance damages, award interest is not tied to your property investment. The IRS sees it as a payment for the delay, so you have to report every dollar of it as income in the year you receive it, even if you use it to pay off the mortgage or make repairs.

How the IRS Sees Each Type of Payment

The IRS looks at severance damages as a return of capital. It’s like getting back some of the money you originally spent on your property. Unless you get more than you paid (your “basis”), you probably won’t owe taxes right away. If the payment is more than your basis, only the extra is taxed, usually at the capital gains rate.

For example, if your basis in the property is $80,000 and you receive $90,000 in severance damages, the first $80,000 just lowers your investment. The remaining $10,000 is considered a capital gain. Depending on how long you owned the property, it could be taxed at a lower long-term capital gains rate.

Award interest is a different story. Since it’s seen as compensation for the use of your money, the IRS treats it as ordinary interest income. It doesn’t matter if you reinvest it or use it to fix up your property. You’ll report it on your tax return for the year you receive it, and it’s taxed at your regular income rate.

If you’re in a higher tax bracket, this can make a big difference. While capital gains tax rates are often lower, ordinary interest income is taxed just like your paycheck. Even a modest amount of award interest can nudge your total tax bill higher than you expect.

Real-World Example: How Taxes Apply

Let’s say the city takes a strip from the edge of your property for a new sidewalk. The loss in value to your leftover land is $25,000. That’s your severance damages. If your original investment (basis) in the property is $100,000, and you haven’t already recovered your investment, you don’t owe tax on the $25,000. It just reduces your basis.

But maybe the whole process takes a year, and you get an extra $1,500 in award interest for the delay. That $1,500 is fully taxable as interest income, even if you turn around and spend it on home repairs. The IRS expects you to report it as ordinary income.

Imagine a business owner whose commercial property is partially taken for a new transit line. The business receives $60,000 for the loss in property value (severance damages) and $5,000 in award interest after a two-year legal battle. The business can usually offset the severance damages against its investment in the property. However, the $5,000 interest is treated as ordinary business income and must be reported for the year it’s received. Not separating these amounts can lead to confusion at tax time and possible IRS scrutiny.