If you’re collecting a legal settlement or judgment, you may be wondering whether it’s considered taxable income. The answer is: yes – usually. But there are exceptions. Here’s what you need to know about taxes and legal settlements.

1. Taxes Will Depend on the Type of Claim You File

Whether or not your settlement is taxed – and how it will be taxed – will depend on the type of claim you file.

  • If the claim is related to work discrimination and you’re seeking lose wages, you would be taxed on wages.
  • If your claim is related to a business loss, you would be taxed on ordinary income.
  • If you sue a builder for negligent damage to your home, your settlement would reduce the purchase price of the home.

As you can see, settlements are taxed as income. But the last example is one exception. Another exception is personal injury.

2. Recoveries for Physical Injuries are Tax-Free, but Emotional Ones are Not

If you’re suing a person or business for physical injuries, your settlement is tax-exempt – as per Section 104 of the tax code.

Prior to 1996, all injuries – physical and emotional – were considered tax-free. Today, the tax-free rule only applies to physical injuries.

This means that personal injury settlements will be taxed if they’re related to:

  • Sexual harassment
  • Emotional distress

Even if your emotional distress causes physical symptoms, like headaches, the settlement would still be taxed. But if you incurred a spinal cord injury due to your employer’s negligence and you collect a settlement, the money would be exempt from taxes. Spinal cord injuries are clearly visible and life-changing, where a headache may simply be a symptom of emotional distress.

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3. Some Settlements are Treated as Capital Gains

Most settlements, unless injury-related, are considered income, which is subject to taxes. But depending on the origin of the claim, that income may or may not be taxed as capital gains.

When claims are related to structural damage (like your home or a business office), the settlement may be considered a capital gain.

4. Punitive Damages and Interest are Taxed

If your settlement award includes punitive damages, they will be subject to taxation. The same rule applies to interest. Pre- and post-judgment interest is taxable. Settling out of court can help you avoid these taxes.

5. Attorney Fees May Add to Your Tax Bill

If your settlement isn’t injury-related, you might consider carefully about how your attorney is paid. If your lawyer works on a contingency-fee basis, meaning he or she only paid if you recover damages, 100% of your settlement would be treated as taxable income.

Injury-related claims are, of course, exempt from this rule. But most other settlements will be treated this way, even if the defendant pays the contingency fee directly.

6. Settlements and Judgments are Treated the Same

It doesn’t matter whether you settle out of court or a jury awards your damages; the same tax rules will apply. But if you choose to settle out of court, you can sufficiently reduce your tax burden.