What Are Severance Damages?

When the government takes part of your property for public use, a process called eminent domain, they may not take the whole thing. Sometimes, only a slice of your land is needed. But what about the value lost to the rest of your property? That’s where severance damages come in. Severance damages are payments you get to make up for the decrease in value to the part of your property you keep after a portion is taken away.

If you’ve ever wondered whether these severance damages are considered a capital gain or ordinary income for tax purposes, you’re not alone. It’s a question that can have a big impact on the taxes you owe.

Severance Damages and Tax Categories: The Basics

The IRS sorts money you earn into different categories. The two main ones you’ll hear about here are capital gain and ordinary income. Capital gain usually comes from selling or losing ownership of something valuable, like your house or land, at a profit. Ordinary income is money you get from your job, business, or things like interest.

Why does it matter? Because capital gains are often taxed at lower rates than ordinary income. So, figuring out if your severance damages fall into the severance damages capital gain ordinary categories can change your tax bill a lot.

How the IRS Treats Severance Damages

The IRS generally treats severance damages as part of the payment for the property taken, not as regular income. That means, in most cases, severance damages are considered proceeds from a partial sale of your property. If you owned the property as an investment or personal asset, the money you receive is usually taxed as a capital gain, not ordinary income.

But there are some catches. The IRS looks at how you use the property and what the payment covers. If you receive money for lost business profits or for damage unrelated to your property’s value, that could be counted as ordinary income. So, context matters.

Example: Residential Property

Imagine you own a home, and the city takes a strip of your backyard to build a new sidewalk. The payment you get for the lost strip is treated as a sale, capital gain rules apply. If the city also pays you because the rest of your yard is now less valuable, that extra payment (the severance damages) is also usually capital gain. It’s all tied to your ownership of the property, not your job or business.

Example: Business Property

Now picture you run a small shop, and the government takes part of your parking lot. The payment for the lost land is a capital gain. If you get extra because your remaining lot is less useful for customers, that severance payment is also usually a capital gain. But if you’re paid for loss of business profits, that part could be ordinary income.

When Severance Damages Might Be Ordinary Income

There are a few situations where severance damages might count as ordinary income instead of a capital gain. The most common is when the payment is meant to replace lost income, not lost property value.

For example, if you own a rental property and the government’s action means you’ll collect less rent, and they pay you to make up for that lost rent, that payment is ordinary income. It’s replacing money you would have gotten as regular earnings.

It’s important to look at what the payment is really for. If it’s for the property itself, think capital gain. If it’s for lost business revenue or rent, think ordinary income.

Figuring Out the Tax: Step-by-Step

If you find yourself dealing with severance damages, here’s a simple way to approach the tax question:

  1. Identify what the payment is for. Is it to make up for lost property value, or for lost profits or rent?
  2. Review how you use the property. Is it a personal home, a rental, or used for a business?
  3. Check if the payment is tied to the property itself. Payments for lost value are usually capital gain. Payments for lost income are ordinary income.
  4. Calculate any gain. If it’s capital gain, subtract your property’s basis (what you paid for it plus improvements) from the total payment to see if you made a profit.
  5. Report it properly on your tax return. Capital gains and ordinary income are reported in different sections.

If you’re unsure, getting professional help can save you trouble later.

Why Getting This Right Matters

Taxes on capital gains are often lower than taxes on ordinary income. That difference can mean you keep more of your severance damages if they qualify as a capital gain. But make a mistake, and you could owe more tax, or face questions from the IRS later.

Understanding the difference helps you plan ahead. It also means you can explain your situation clearly if the IRS ever asks.

Common Questions About Severance Damages

Are all severance damages taxed the same way?

No, not all severance damages are treated the same. Most are taxed as capital gain, but payments meant to replace lost income or profits can be taxed as ordinary income. The key is figuring out what the payment is really for.

What paperwork should I keep?

Hold on to anything that explains why you received the payment, like government letters, settlement agreements, and property appraisals. These documents help show how you reported the payment on your taxes.

Can I defer or exclude tax on severance damages?

Sometimes. If you use all the money to buy similar property, you might qualify for a tax deferral under certain IRS rules, like a Section 1033 exchange. But the rules are strict and deadlines are tight, so it’s smart to ask a tax advisor early.

Conclusion

Severance damages can be taxed as capital gain or ordinary income, depending on what the payment covers. Most of the time, payments for loss of property value fall under capital gain rules, but payments for lost business income or rent are ordinary income. Knowing the difference helps you avoid surprises at tax time. Contact us to learn more.