Ever wondered what happens when the government takes part of your property for a public project and pays you for it? If you’re in a partnership, those payments, called severance damages, can make tax season feel confusing fast. This guide will walk you through how form 1065 severance damages work, why they matter, and what you need to do to report them correctly on your partnership return.

What Are Severance Damages?

Severance damages are payments made to property owners when only part of their property is taken, usually through a process known as eminent domain. Instead of buying the whole property, the government might take just a portion, maybe a strip of land for a new sidewalk or road expansion. The payment you get is meant to cover the loss in value to the part of your property you still own.

For partnerships, severance damages can be a bit more complicated than they seem. Not only do they affect your bottom line, but they can also have a big impact on your tax reporting. That’s why understanding how severance damages fit into your tax filings is so important.

Severance damages are different from the payment you’d get if the entire property were taken. When you only lose part of your property, the value of what’s left might drop. Severance damages are meant to make up that loss, but the IRS cares about how you treat that money on your tax return.

How Severance Damages Affect Partnerships

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When a partnership owns property, severance damages are split among the partners according to the partnership agreement. But how those payments get taxed depends on several factors, like how the property is used, how your partnership agreement splits income and losses, and what the damages are actually for.

Severance damages might look like a windfall, but the IRS wants careful reporting on Form 1065 (the partnership tax return). Misreporting can lead to problems, including audits, penalties, or big tax bills later on. That’s why it’s important to understand the basic principles before you file.

Types of Severance Damages

Not all severance damages are created equal. You’ll often see two main types:

  1. Compensation for loss in property value. This is the most common, paid to make up for the lower value of the remaining property after part is taken.
  2. Reimbursement for out-of-pocket expenses. These can include moving expenses, costs to fix up or repair the remaining property, or even legal fees if you had to fight for a fair payment.

Each type is taxed differently. For example, money received for lost value might reduce your investment (called your basis) in the property, while reimbursements for expenses could be matched to deductions. Keeping detailed records will help you figure out exactly what you received and how to report it.

Let’s say your partnership owns a warehouse, and the city takes a corner of the lot to add a sidewalk. If the payment is just for the loss in value to the warehouse, that’s one thing. If you’re also paid to move a fence or replace landscaping, those payments might be reported differently.

Where to Report Severance Damages on Form 1065

Where do you actually put severance damages on your partnership tax return? Here’s what you need to know:

  1. Decide if the payment is a return of capital (your original investment) or a gain. If the severance damages exceed your basis (your share of what you paid for the property), the excess is usually a taxable gain.
  2. Report any gain as income on Form 1065. This often goes under “Other Income,” but the precise line can vary depending on the situation. For some partnerships, it may need to be reported as a capital gain if you held the property for investment.
  3. Match reimbursed expenses, like legal fees or repairs, to the right deduction or income lines. This step ensures you’re not taxed on money you only received to cover costs.

The IRS instructions for Form 1065 provide guidance, but situations can get complicated. For example, if your partnership used the land for business, the gain might be ordinary income. If it was investment property, it could be a capital gain. The key is to look carefully at the source of the payment and how the property was used.

Example: Reporting Severance Damages Step-by-Step

Let’s walk through a more detailed example. Imagine your partnership owns a strip of land used for a parking lot. The city takes 10 feet along one side to widen a road, paying your partnership $50,000 in severance damages.

  1. First, check your basis in the land. If your partnership’s basis is $30,000, the first $30,000 of the payment reduces your basis in the property. After this, your basis in the land is zero.
  2. The remaining $20,000 ($50,000 minus $30,000) is a gain. If the property was held as an investment, this gain could be reported as a capital gain on Form 1065. If it was used in an active business, it might be ordinary income instead.
  3. Let’s say the partnership also received $5,000 to repave the lot. That amount should be matched to the cost of the repairs. If you spent the full $5,000 on repairs, your taxable income doesn’t increase because the payment just covers your out-of-pocket costs.
  4. After all this, each partner’s share is reported on their individual Schedule K-1. The partnership allocates both the gain and any deductions for expenses according to your agreement.

This is just one scenario. Your partnership’s situation could be different, especially if you financed the property, have depreciation, or share ownership with other businesses. For example, if you have a mortgage on the property, the calculation of gain might change. Likewise, if the property has been depreciated for tax purposes, you could face different tax rates on the gain.

Common Mistakes and How to Avoid Them

Reporting form 1065 severance damages can get tricky fast. Here are some common pitfalls:

  1. Not keeping detailed records. It’s easy to forget what each payment was for if you don’t track it from the start. Always keep a copy of the government’s offer, your own notes, and any receipts for repairs or legal fees.
  2. Forgetting to adjust your basis in the property. If you don’t reduce your basis when you get severance damages, you might report the wrong gain later when you sell the property.
  3. Treating all severance payments as income. Some payments just reduce your investment and aren’t taxable until your basis is used up.
  4. Missing out on deductions. If you’re paid to cover expenses like repairs, match those payments with your actual costs so you’re not taxed on money you just passed through.
  5. Overlooking allocations. Each partner’s share must be reported correctly on Schedule K-1, reflecting both income and deductions.

Let’s add a quick example: Suppose your partnership fails to match $10,000 of reimbursed repairs to actual costs. You might end up paying tax on the full $10,000, even though you didn’t really make a profit. A little extra care can save a lot of headaches.