If your property has been affected by eminent domain, you might have received a payment called severance damages. But when tax season rolls around, a common question pops up: are severance damages taxable? If you’re unsure what to do with this type of payment, you’re not alone. In this guide, we’ll break down what severance damages are, how the IRS views them, and what you need to know to handle them on your taxes. By the end, you’ll have a clear answer and know where to turn for more help if things get complicated.

What Are Severance Damages?

Let’s start with the basics. Severance damages are payments made to a property owner when only part of their property is taken for a public project, like a new highway, school, or utility line. Instead of buying the whole property, the government takes just a section, maybe it’s part of your backyard or a strip along the edge of your land. If this partial taking reduces the value of the part you keep, you could receive severance damages to make up for the loss. It’s a way to compensate you for the negative impact on the property’s remaining value, not just for the land the government actually takes.

For example, imagine you own a home with a big backyard, and the state decides to put a road through the back third of your lot. You get paid for the land taken. But now, your once-quiet yard is much smaller and right up against a busy street. If the rest of your property is worth less now than before, severance damages are meant to cover that drop in value. These payments are separate from the money you get for the part of your property that’s taken outright. They’re about what’s left and what it’s now worth.

Severance damages can also pop up in commercial situations. Suppose you own a gas station, and the city takes away part of your parking lot for a new sidewalk. If that makes your business less attractive or harder to access, the value of your property goes down. Severance damages help bridge that gap.

How the IRS Views Severance Damages

Now, on to the big question: are severance damages taxable? The short answer is, it depends. The IRS generally treats severance damages as a form of compensation for the reduction in your property’s value after a partial taking. But whether you owe tax on that money depends on a few key factors, mainly your property’s adjusted basis, or what you originally paid for it (plus the cost of improvements, like renovations or additions).

Here’s how it works in a nutshell: If the total of all payments you receive, both for the land taken and for severance damages, doesn’t exceed your property’s adjusted basis, you typically won’t owe tax. The payments are considered a return of your investment in the property. But if the payments go above your basis, you might have a taxable gain. In other words, only the amount over your original investment (plus improvements) is usually taxable.

Keep in mind, the rules are designed to be fair. The IRS isn’t looking to tax you on recovering your own money, it’s the extra, above what you put in, that can count as a gain. The details can get tricky, so let’s walk through the calculations together.

Calculating Taxable Amounts: Step by Step

Understanding if your severance damages are taxable comes down to some simple math. Here’s how you can figure it out for your own situation:

  1. Add up all payments you receive for the portion of property taken and any severance damages.
  2. Find your property’s adjusted basis, this is usually what you paid for the property, plus the cost of major improvements (like building a deck or adding a new roof).
  3. Subtract your adjusted basis from the total payments received.
  4. If the total is less than or equal to your basis, you likely don’t owe tax.
  5. If the total is more than your basis, the extra amount may be taxable as a capital gain.

Let’s look at a real-world example. Say you bought your house for $200,000, and you put $20,000 into renovations over the years. That makes your adjusted basis $220,000. The government takes a corner of your yard, paying you $40,000 for the land and $30,000 in severance damages, a total of $70,000. Since $70,000 is less than $220,000, you probably won’t owe any tax on that payment. But if your total payments were $250,000, the $30,000 above your basis could be taxable as a capital gain.

This math works the same way whether you own a home, rental property, or business property. Always keep good records of what you paid and any improvements you made. If you inherited the property, your basis might be its value when you inherited it, not what the previous owner paid.

Remember, the timing of these payments can also matter. Sometimes you get paid in more than one year, or the government makes an initial payment and a final settlement later. Each payment should be added to your total for the calculation.

Special Situations and Exceptions

Not every case is cut and dried. There are a few wrinkles to be aware of when figuring out if severance damages are taxable. These special rules can make a big difference in your tax bill, depending on how you handle the payments.

Replacement Property (Section 1033 Exchange)

If you use the money from the government to buy a similar property within a certain time (usually two or three years), you might be able to defer paying any tax. This is known as a Section 1033 exchange. It works a bit like trading in your property instead of selling it. By reinvesting all the money you received, both for the land and for severance damages, into a new, similar property, you can postpone the tax bill until you eventually sell the new property. There are strict deadlines and paperwork requirements, so it’s important to plan ahead and talk to a tax professional if you’re thinking about this option.

Let’s say your property was partially taken and you received a combined payment. If you quickly buy another similar property (like another house or rental), you might not owe tax now. But if you pocket the money or wait too long, you’ll likely owe tax on any gain over your basis.

Different Types of Property

Rules can change depending on the kind of property you own. If it’s your main home, you might qualify for special tax breaks. For example, if you’ve lived there at least two of the last five years, part of any gain from selling your main home might be tax-free. For rental or business properties, different rules and deductions may apply. Sometimes, states have their own special rules for agricultural land or historic properties. Don’t assume all properties are treated the same, always double-check based on your situation.