What Are Severance Damages?

Before diving into foreign owner severance damages tax, let’s start with what severance damages actually are. Severance damages are payments made to a property owner when the government takes only part of their property under eminent domain. Eminent domain is the government’s legal right to take private property for public use, like building new roads or utilities, as long as the owner is paid fairly.

Let’s make this real. Imagine you own an apartment building. The city decides it needs a strip of land running through your property for a new subway line. They take just a part of your land, not the whole thing. But now your remaining property is harder to access, or maybe it’s worth less on the market. That drop in value is what severance damages are meant to cover. They aren’t an extra bonus, they’re compensation for the real loss in value or usefulness of what you still own.

Severance damages can come into play with all kinds of property: homes, commercial buildings, farmland, or even undeveloped lots. The loss could be about money, but it can also be about lost access, changes to traffic patterns, or new noise that affects your building. These payments are meant to help you recover from those changes.

How Severance Damages Are Taxed in the U.S.

Now let’s talk about tax. In the United States, getting severance damages is usually a taxable event. That means when you receive this payment, the IRS expects you to report it on your tax return. The way it’s taxed depends on your original investment in the property, what’s called your “basis.”

Think of it like this. If you bought your property for $200,000 and the government pays you $50,000 in severance damages, the IRS looks at whether that $50,000 is more than what you originally invested in the portion taken. If it is, you may owe capital gains tax on the difference. If not, you may have no gain at all, but you still need to report it.

Sometimes, if you use the severance damages payment to fix or replace what was lost, or buy similar property, you might be able to defer the tax using a process called a Section 1033 exchange. This is a special rule that lets you put off paying tax if you reinvest the money within a certain timeframe, usually two to three years. It’s a little like trading in your old car for a new one without paying sales tax right away, but for property instead of cars.

There are details that matter. You’ll need to keep careful records of what you paid for your property, what portion was taken, and how you used any severance damages received. If you mix up the numbers or miss deadlines, you could end up owing more than you expected.

Special Tax Rules for Foreign Owners

If you’re a foreign owner, meaning you’re not a U.S. citizen or green card holder, the rules are different, and often more complicated. Any severance damages you get from U.S. property are considered U.S.-source income. That’s true whether you live in Canada, Japan, the UK, or anywhere else outside the U.S.

Here’s what that means: even if you never set foot in the United States, the IRS still expects you to pay tax on income tied to U.S. property. Severance damages count as this type of income. You can’t simply ignore it or only report it in your home country. The U.S. government wants its share.

But there are some lifelines. The U.S. has tax treaties with many countries that can lower your tax rate or change what income is taxed. For example, some treaties reduce the standard tax rate on capital gains or allow you to claim credits in your home country for taxes paid in the U.S. These treaties are all different, so it’s worth checking the specific agreement between your country and the U.S. Many foreign owners miss out on savings simply because they don’t realize a treaty exists.

Let’s look at an example. Say you’re a resident of Germany and you get $40,000 in severance damages from property you own in the U.S. The standard tax might be 15%, but the U.S.-Germany tax treaty could lower it or let you get credit back home. Every country’s treaty is different, so you need to look up your own or get professional help.

How Withholding Works for Foreign Owners

Withholding is a key part of the foreign owner severance damages tax process. Withholding is when the payer, often a government agency, holds back a portion of your payment and sends it directly to the IRS. The idea is to make sure taxes are collected upfront, so foreign owners don’t accidentally (or intentionally) skip paying what’s owed.

Under the Foreign Investment in Real Property Tax Act (FIRPTA), withholding is usually 15% of the payment. So if you’re owed $50,000 in severance damages, the agency might send you $42,500 and send $7,500 directly to the IRS. The agency should also provide you with forms showing what was withheld.

Here’s a step-by-step example of how this works:

  1. The government agency notifies you that a portion of your property will be taken under eminent domain.
  2. You negotiate or agree on the amount of severance damages owed.
  3. Before payment is made, the agency withholds a percentage (often 15%) for federal taxes.
  4. The withheld amount is sent to the IRS, while you receive the remaining balance.

This withholding isn’t always the final word. You’ll still need to file a U.S. tax return for that year. If too much was withheld, you might get a refund. If not enough was withheld, you may owe more. Either way, filing a return is the only way to settle up.

Filing Requirements and Avoiding Double Taxation

So what do you actually have to do if you’re a foreign owner who received severance damages? First, you’ll probably need a U.S. taxpayer identification number (ITIN) if you don’t already have one. This number is required to file a U.S. tax return and claim any refunds or treaty benefits.

When you file, you’ll report the severance damages as U.S.-source income, show the amount that was withheld, and claim any deductions or treaty benefits you qualify for. It’s important to file on time, usually by June 15 for nonresident aliens, though extensions are possible.

Double taxation, being taxed by both the U.S. and your home country on the same payment, is a common concern. Most countries with a U.S. treaty will let you claim a tax credit for what you paid in the U.S. That way, you don’t pay tax twice on the same money. To do this, keep detailed records: copies of the property transaction, payment statements, withholding forms, and proof of any tax paid.

Skipping filing can cause headaches. If you don’t file, you could lose out on refunds, face penalties, or get flagged by the IRS in the future. It’s much easier to keep up with the paperwork than to fix problems after the fact.