Hurricane Katrina

[amonEA]

This client in 2005 had a complete loss from a rental property. We claimed the casualty loss on Form 4684. The amount of the loss was around $150K. The client did not have any insurance or other reimbursements on Form 4684. During the tax year of 2007 she has been reimbursed for this loss through a Government assisted Grant. In the same amount. Also she has received a lawsuit settlement in excess of the grant that totaled around $125K less the legal fees of around $42K. The law firm reported this on a Form 1099-MISC as other income. I understand because she took a loss in a prior year that the grant money should be taxable for the amount of the loss. However should we include the Lawsuit as other income as well? Or should we include it as a Capital Gain due to the excess received from the storm?

2005 Casualty Loss= 150K
2007 Grant Proceeds= 150K
2007 Lawsuit proceeds= 125K
2007 Legal Fees= 42K

[Koss]

Lawsuit Settlement

The tax treatment of that settlement may hinge on how the settlement agreement was drafted.

There is a general principle that money you receive from a lawsuit, whether through a settlement or through an actual judgment, is not taxable if it is compensatory damages. In other words, if the payment simply "makes you whole again," after your loss, then you don't have taxable income because you haven't really gained anything.

But clearly, from a raw numbers perspective, your client appears to have gained something, because the grant made her whole again. So on this analysis, the entire settlement, minus the fees, is gravy, or extra money.

But if the terms of the settlement spell out explicitly that she was compensated for something other than the loss of the property, then part or all of the settlement proceeds may not be taxable.

There is a separate question about whether you can back out the legal fees directly, or whether you have to take the fees as an itemized deduction, or as the case may be, a deduction on Schedule E. But how can there be a Schedule E for 2007 if the rental property doesn't exist anymore?

I guess I'm just thinking out loud here. I recommend reading the terms of the settlement agreement as a starting point.

As for the grant, it's considered a recovery, since it the casualty loss was deducted in a previous year. IRS Publication 525 directs us to report the recovery on line 21 as other income. This appears to preclude capital gain treatment for the grant.

I'm not sure I follow your reasoning with respect to capital gain treatment for the lawsuit settlement proceeds... are you trying to treat the money as proceeds from the disposition of the property?

[amonEA]

Katrina Loss

On the casualty loss Form 4684 there is a line 4 item that says gain from the casualty. I was thinking that the lawsuit would be in excess of her original deduction and would be a gain due to casualty. Which is termed a capital gain? Maybe I am wrong but it seems she has a gain from the storm?

Thanks for your help with this information. I really do appreciate it!!