Even the Internal Revenue Service admits that circumstances exist where money should not be taxed, but few issues are that cut-and-dried with the IRS. Sometimes it taxes accident settlements, and sometimes it doesn't. Sorting through the rules can be complicated, and exceptions exist to many of them.
Compensation you receive for injuries sustained in an accident isn't taxable, and most other rules stem from this one. If you slip on a wet patch in the grocery store aisle and break your limbs, anything the insurance company pays you for this is tax-free. Likewise, if you're stopped at a red light and another car plows into you from behind, you don't have to pay taxes on money the driver's company gives you to settle. The IRS takes the position that these sums are intended to restore you to the condition you were in before the accident occurred, so it leaves them alone. The same usually holds true for any payments meant to cover your medical bills.
If you fall into a deep depression after your grocery store or vehicular mishap, a settlement compensating you for your suffering might be taxable, depending on your depression's cause. If you're depressed because your injuries have robbed you of your independence, compensation for your suffering is tax-free. If your depression results from the fact that your beloved pet was killed in the accident, however, this money is taxable because it's not directly related to your injuries. The IRS only spares pain and suffering settlements if the claim is a direct result of your physical ailments.
Recoveries for property damage can be taxable under certain circumstances. If your $25,000 automobile suffers $10,000 in damage and if your settlement compensates you for this, the $10,000 is tax-free. The concept is similar to the concept the IRS uses regarding personal injury – the $10,000 made your vehicle whole again. It brought its value back to what it was before the accident. You don't even have to use the $10,000 to repair your vehicle if you don't want to. If the insurance company gives you $15,000, however, $5,000 of that is taxable. You must claim as income anything you receive in excess of your car's estimated damage. This is rare when a lawsuit is settled rather than litigated, however – it's unlikely that the insurance company would voluntarily give you more money than what the damage to your vehicle amounted to.
Wrongful death suits fall into a category all their own. If the settlement is punitive in nature, it's typically taxable – it represents punishment or an admission of guilt for some wrongdoing. Some states only allow punitive awards in wrongful death cases, however, and if you live in one of them, you're off the hook – the IRS won't tax the proceeds because you and the insurance company had no other option. Otherwise, your wrongful death settlement escapes taxation only if it's compensatory, and your settlement agreement should clearly spell this out. Just as with physical injuries and property damages, compensatory wrongful death awards are meant to try to restore survivors to the condition they were in before the accident and the death of their loved one occurred. In this case, the money is tax-free.
If you took any tax deductions related to your accident while you were waiting for your lawsuit to settle, you have to add this money back on your tax return when you receive your settlement. For example, if you paid out-of-pocket for some medical bills, and if you then took a tax deduction for those medical expenses, the portion of your settlement that reimburses you for that money is taxable income.
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