When the government takes a piece of your property for public use, like widening a road or building new utilities, you might hear the term “severance damages.” Ever wondered how is severance damages taxed? This guide explains everything you need to know in plain language, so you’re prepared if it happens to you.

What Are Severance Damages?

Severance damages are a type of compensation paid to property owners when only part of their land is taken through eminent domain. Imagine your backyard gets cut in half to make way for a new highway. You’ll get paid for the piece taken, but if the rest of your property loses value because of the change, severance damages help cover that loss.

For example, let’s say you own a house with a big yard and a nice view. If the government takes a strip from the edge, and now your view is blocked or your property is harder to access, severance damages might be paid to make up for that drop in value. These damages are separate from the payment for the actual land taken.

How Is Severance Damages Taxed?

Now, here’s the big question: how is severance damages taxed? The answer isn’t always simple, but here’s the general idea.

Severance damages are usually treated as part of the sale or forced sale of property under the law. That means the IRS considers the money you receive as a payment for property. In most cases, it’s taxed in the same way as if you’d sold that part of your land.

If you’ve owned the property for more than one year, the payment is typically considered a long-term capital gain. That means it’s taxed at the lower capital gains rate, not ordinary income tax rates. If you’ve owned it for less than a year, it counts as a short-term gain and is taxed at your normal income rate.

But, and this is important, if the payment is less than what you originally paid for your property (your “basis”), you might not owe any tax at all. The IRS lets you reduce your basis in the remaining property by the amount of severance damages received before you have to report a gain.

The Role of Your Property’s Basis

Your “basis” is what you paid for the property, plus certain improvements. It’s the number you use to figure out your gain or loss when you sell or lose part of your property.

Let’s break it down with an example. Suppose you bought your land for $200,000. The government takes a strip and pays you $50,000 in severance damages. If your property’s new value is reduced by $50,000, you can lower your basis in the remaining property by that amount. You only report a taxable gain if you get more in compensation than your basis allows. This rule helps make sure you’re not taxed on money that just brings you back to even.

Situations That Affect Tax Treatment

Not every case is the same. Sometimes, the way severance damages are taxed depends on what you do with the money and how the taking is handled.

Reinvesting Through “Involuntary Conversion”

If you use the money from severance damages to buy similar property within a certain time, you might be able to defer taxes. This is called an “involuntary conversion.” It’s a tax rule that lets you put off paying on the gain if you replace what you lost.

The IRS allows you to defer the tax if you reinvest within two or three years (depending on the situation), but there are strict rules about what counts as a qualified replacement. Keeping good records is key if you plan to use this option.

State Taxes May Differ

Federal rules aren’t the only ones you need to think about. Some states follow the IRS approach, but others have their own rules about taxing severance damages. In some places, you might pay more or less, depending on local law. It’s a good idea to check with a tax professional in your state so you’re not caught off guard.

Common Misunderstandings About Severance Damages and Taxes

There are a few myths that trip people up when it comes to severance damages and taxes. Let’s clear them up.

First, some folks think all compensation from eminent domain is tax-free. That’s not true. While certain government payments (like disaster relief) can be tax-free, severance damages are usually taxable if you realize a gain.

Second, people sometimes assume that if they spend the money on fixing up the rest of their property, it won’t be taxed. That isn’t the case unless you meet the specific requirements for an involuntary conversion.

Finally, others believe that severance damages are always taxed at ordinary income rates. As you’ve seen, the rate depends on how long you’ve owned your property.

Tips for Handling Severance Damages on Your Taxes

Getting a check for severance damages can be confusing. Here’s how to keep things simple and avoid problems with the IRS.

  1. Keep careful records of what you originally paid for your property (your basis) and any improvements you’ve made.
  2. Get a clear breakdown from the government or condemning authority showing what part of your payment is for land taken and what part is severance damages.
  3. If you’re not sure about your tax situation, talk to a tax professional who understands eminent domain issues. The rules can get tricky, especially if you want to take advantage of tax deferral options.
  4. File the right forms with your tax return. Severance damages are usually reported on IRS Form 8949 and Schedule D, along with your other capital gains and losses.

Doing these things can help make sure you don’t pay more tax than you have to, or get hit with an unexpected bill later.

Conclusion

Severance damages can be a lifeline when part of your property is taken, but taxes can complicate things. In most cases, the key is understanding your property’s basis and how the IRS treats these payments. If you’re facing an eminent domain situation, it pays to get advice tailored to your specific case. Contact us to learn more.