Property lawyers and clients resolve disputes, usually with a release and an exchange of money. Money changes hands anytime; there are tax issues for both sides coming up in surprising ways. Perhaps your car was stopped at a red light, your contractor did careless work on your condo, you were fired, or someone hurt you. As a result, you are collecting a judgment or settlement payment.
The first question in those situations is whether the judgment or settlement payment is taxable income, and the answer is always “yes.” For more clarity, here are ten rules every property lawyer and client should know about taxation of settlements. You can get more valuable information about property law on https://chamberlains.com.au/property-law
1. Judgments settlements Are Taxed the Same
The same tax law applies whether you are paid to settle a case or win a judgment. Despite this similarity, you will almost always have more flexibility to reduce taxes if a case settles rather than goes to a conclusion. You must show what the issue was about and what you sought in your claims if you are audited. Consider the settlement agreement, the complaint, and how payments were made to resolve the case. You can influence how recovery is taxed by dealing with those issues. Learn more about property taxes in Australia.
2. Taxes is determined by the origin of the claim.
Judgments and Settlements are taxed according to the matter for which the plaintiff sought recovery (the origin of the claim). If a property lawyer uses a business for lost profits, a settlement or judgment will be considered lost profits taxed as ordinary income. Suppose you are laid off from work and sue for discrimination seeking wages and severance. In that case, you will be taxed on your settlement or judgment as having received wages.
Your former employer will withhold employment and income taxes on all settlements if you have not worked there for several years. On the contrary, if you sue for damage to your condo by a negligent building contractor, injuries usually won’t be considered revenue. Instead, the recovery can be treated as reducing the condo’s cost. That favorable rule means you might not pay tax on the money you collect. However, these rules contain exceptions and nuances, so be careful.
Related: Why You Need a Property Lawyer in Your Real Estate Investment
3. Recoveries for Physical Injuries and Sickness Are Tax-Free
That fundamental rule causes almost unending confusion among property lawyers and their clients. Suppose you sue for personal physical injuries resulting from, for example. In that case, your compensatory damages should be tax-free, such as a slip and fall or a car accident. That may seem odd because you seek lost wages if you cannot work after your injuries. However, a specific section of the tax code shields damages for personal physical injuries and physical sickness.
4. Signs of Emotional Distress Are Not “Physical.”
Tax law distinguishes between the money you receive for physical symptoms of emotional distress (like headaches and stomachaches) and physical injuries or sickness. Here again, these lines are not clear. For example, in settling the dispute, suppose that you collect an extra $60,000 because your staff gave you an ulcer. Is that ulcer considered “physical”, or is it merely a symptom of your emotional distress? As a property lawyer, you need to be able to tell the difference.
5. Medical Expenses Are Tax-Free
I have heard about cases where property lawyers claim to attach a tax to their medical expenses. That’s out of the radar! Even if the injuries are purely emotional, payments for medical expenses are tax-free, and what constitutes “medical expenses” is surprisingly liberal. For example, amounts to a psychiatrist or counsellor qualify as payments to a chiropractor or physical therapist. Many nontraditional treatments count as well.
However, suppose you have previously deducted the medical expenses and are reimbursed when your suit settles in a subsequent year. In that case, you may pay taxes on them. Suppose you deducted an amount in a previous year, and that deduction produced no tax benefit to you. In that case, you can exclude the recovery of that amount in a later year from your gross income.
6. Allocating Damages Can Save Taxes
Most legal disputes about properties involve multiple issues. Still, even if your dispute relates to one course of conduct, there is a good chance the total settlement amount will affect various categories of damages. The plaintiff and defendant should agree on what is paid and its tax treatment. Such agreements are not binding on the courts in later tax disputes but are rarely ignored. Then, a property lawyer must spell this fact out to clients when damage issues arise.
7. Look for Capital Gain
Outside the suits for physical injuries or sickness, just about everything is income; however, that does not answer any question on how it will be taxed. Suppose your suit is about damage to a residential or commercial building. In that case, the resulting settlement may be treated as a capital gain. Long-term capital gains are taxed at a lower rate (15 per cent or 20 per cent, plus the 3.8% Obamacare tax, not 39.6 per cent). It is, therefore, much better than ordinary income.
Aside from the tax-rate preference, tax basis may also be relevant. That generally is your original purchase price, increased by any improvements you have made and decreased by depreciation, if any. In some cases, the settlement of a property lawyer may be treated as a recovery of basis, not income.
8. Property Lawyers’ Fees Can Be a Trap
Legal fees will impact net recovery and clients’ taxes if a property lawyer charges hourly or on a contingent-fee basis. If plaintiffs use a contingent-fee property lawyer, they usually will be treated (for tax purposes) as receiving 100 per cent of the money recovered by the client and the lawyer. That is so even if the defendant pays a property lawyer the contingent fee directly.
9. Punitive Interest and Damages Are Always Taxable
Punitive damages and interest are taxable, even if injuries are 100 per cent physical. Suppose one is injured in a car crash and receives $40,000 in compensatory and $10 million in punitive damages. The $40,000 is tax-free, but the $10 million is fully taxable.
10. It Pays to Consider the Defense
Clients generally are much more worried about tax planning than defendants. Nevertheless, consider the client’s perspective as well. A defendant paying a judgment will want to deduct it. If the defendant engages in a business, doing so rarely will be questioned, given that litigation is a cost of doing business. Even punitive damages are tax-deductible by companies.
In Conclusion
Every property lawyer needs to have a complete understanding of the provision of the law in every situation. That is one of the best ways to do your job like a pro. This article is majorly written to get new property lawyers familiar with the demands of the new field they have chosen. Although you might have learned a lot in college, the above rules will help you make informed decisions in difficult situations.
