Many taxpayers recently received payments due to the settlement of class-action lawsuits regarding corrosive or defective drywall. These questions and answers are intended to assist homeowners with how to properly report drywall settlement payments on their federal income tax returns. The questions and answers explain a number of rules affecting the proper reporting of these payments and offer examples to illustrate how these rules are applied. 1. Question. I received a payment to settle a lawsuit solely for damage to my home caused by corrosive drywall. Do I have to include the settlement payment in income on my tax return? Answer. Whether the settlement payment is income that you must report on your tax return depends on a number of factors, including whether you deducted a casualty loss on a previous year’s tax return. See Questions 3, 4 and 5 to help you determine how much, if any, of the settlement payment you must include in income on your income tax return. 2. Question. What if I received a Form 1099 showing the amount of the settlement payment? Answer. A Form 1099 would not tell you if you must include in your income the settlement payment solely for damage to your home from corrosive drywall. Whether you receive a Form 1099 or not, you must determine if the settlement payment must be included in your income. Questions 3, 4 and 5 will help you determine how much, if any, of the settlement payment you must include in income on your income tax return. 3. Question. What if I took a casualty loss deduction in an earlier year and receive a settlement payment this year? Answer. A “recovery” is a return of an amount you deducted in an earlier year. You must include a recovery in the year you receive it, up to the amount by which the deduction you took for the recovered amount reduced your tax in the earlier year. This is called the “tax benefit” rule and it may affect your current year tax liability if you claimed a casualty loss deduction in an earlier year tax return on Form 4684 PDF, Casualties and Thefts. More information on the tax benefit rule can be found in Publication 525, Taxable and Nontaxable Income, including how to determine the amount of your recovery that you must include in income under the tax benefit rule. You can figure this amount by using Worksheet 2 in Publication 525. You generally are allowed to claim the standard deduction if you do not itemize your deductions. Only your itemized deductions that are more than your standard deduction are subject to the recovery rule. You do not include in your income any amount of your recovery that is more than the amount you deducted on your income tax returns in the earlier year for that particular deduction item. The amount you include in your income is limited to the smaller of: The amount deducted, or The amount recovered. Example: Payment less than earlier year deduction. You and your spouse properly claimed a casualty loss deduction on your 2013 tax return of $14,000. You also claimed a $10,000 deduction for mortgage interest; because you itemized, you did not take the $12,200 standard deduction available to joint filers for 2013. In 2014, you received a drywall settlement of $13,000. To figure the amount of the $14,000 deduction you have to repay, complete Worksheet 2 in Publication 525. Include $11,800 of the recovery in your 2014 income. This is the smaller of your recovery ($13,000) or the amount by which your itemized deductions were more than the standard deduction ($24,000 - $12,200 = $11,800). Example: Payment greater than earlier year deduction. You and your spouse properly claimed a casualty loss deduction on your 2013 tax return of $15,000. You also claimed a $10,000 deduction for mortgage interest; because you itemized, you did not take the $12,200 standard deduction available to joint filers for 2013. In 2014, you received a drywall settlement of $40,000. To figure the amount of the $15,000 deduction you have to repay by completing Worksheet 2 in Publication 525. Include $12,800 of the recovery in your 2014 income. This is the smaller of your recovery ($40,000) or the amount by which your itemized deductions were more than the standard deduction ($25,000 - $12,200 = $12,800). To figure how much you have to include of the additional $25,000 (the portion of the $40,000 payment that is more than your 2013 deduction of $15,000), you use the same rules that are described in Questions 4 and 5. 4. Question. I received a settlement payment solely for damage to my home caused by corrosive drywall in my home. I never claimed a deduction on my income tax return for any damage from the drywall. How can I tell whether I have income or not? Answer. Whether you have income from the settlement payment depends on whether you have a gain from the settlement payment. Whether you have a gain depends on whether the settlement payment is more than your “adjusted basis” in your home. Your adjusted basis is the amount you paid for your home (your “cost basis”) increased by the cost of certain improvements and decreased by certain other items. For more information, see Publication 523 PDF, Selling Your Home. For more information on basis, see Publication 551 PDF, Basis of Assets. For detailed information on how to figure whether you have a gain and, if you do, the amount of the gain, see Figuring a Gain, in Publication 547 PDF, Casualties, Disasters, and Thefts. Similar information for figuring gain from a sale or exchange is in Publication 544 PDF, Sales and Other Dispositions of Assets. You have a gain to the extent your settlement payment is more than your adjusted basis in your home. See Question 5 to determine whether you must include this gain in your income on your income tax return. You do not have a gain and do not include the settlement payment in income if your settlement payment is less than or equal to your adjusted basis in your home. Example. You received a $40,000 settlement payment solely for damage that corrosive drywall caused to your home, and you never claimed a casualty loss deduction on Form 4684 PDF, Casualties and Thefts. Your adjusted basis in your home when you received the payment was $85,000. Because the payment of $40,000 is less than your adjusted basis of $85,000, you do not include the $40,000 settlement payment in your income. However, you must reduce your adjusted basis in your home by the $40,000 payment. Your adjusted basis in your home is now $45,000 ($85,000 - $40,000 = $45,000). 5. Question. I never claimed a deduction on my income tax return for any damage from the corrosive drywall and the settlement payment I received was more than my adjusted basis in my home. Do I have to include this difference in income on my income tax return? Answer. You have a gain to the extent your settlement payment is more than your adjusted basis in your home. However, under the rules for excluding gain from the sale of your main home, you may be able to exclude this gain from your income if the corrosive drywall was in your main home and you satisfy certain conditions. Generally, if the corrosive drywall was in your main home, you can exclude from income up to $250,000 of the gain from the settlement payment if the following is true: You owned the home and used it as your main home during at least 2 of the last 5 years before destruction of the home due to the corrosive drywall. You did not acquire the home through a like-kind exchange (also known as a 1031 exchange) during the past 5 years. You did not claim any exclusion for the sale of a home that occurred during a 2-year period ending on the date of the destruction of your home due to the corrosive drywall, the gain from which you now want to exclude. Married taxpayers filing jointly. If you are married and file jointly, and the corrosive drywall was in your main home, you can generally exclude from income up to $500,000 of the gain from the settlement payment if the following is true: You or your spouse owned the home and both of you used it as your main home during at least 2 of the last 5 years before destruction of the home due to the corrosive drywall. Neither you nor your spouse acquired the home through a like-kind exchange (also known as a 1031 exchange) during the past 5 years. Neither you nor your spouse claimed any exclusion for the sale of a home that occurred during a 2-year period ending on the date of the destruction of your home due to the corrosive drywall, the gain from which you now want to exclude. Even if you do not satisfy each of these tests, you might be able to exclude some of the gain from your income. Publication 523 PDF, Selling Your Home, includes information on these tests and when you might be able to exclude gain even if you do not satisfy each of these tests. In other situations, certain gain is ineligible to be excluded from your income even if you meet each of these tests. See Publication 523 for additional information about ineligible gain and other helpful information. In addition, instead of electing to exclude the gain from your income, you may elect to postpone recognizing the gain if you restore your home and the restoration costs are at least as much as your settlement payment. For further information, see Publication 547 PDF, Casualties, Disasters, and Thefts, and Publication 544 PDF, Sales and Other Dispositions of Assets. Related Item: Forms & Publications
