Generally, car accident settlements are not taxable. However, there are exceptions.
Ultimately, only your tax advisor can give you definitive tax advice. The information in this article is designed to help you decide what issues you should discuss with your tax advisor.
In most cases, car accident settlements include recoveries for property damages and personal injuries. Personal injury settlements, in turn, include payment for medical bills, lost income and pain and suffering. Occasionally, there are also punitive damages.
Let’s look at each of these possible car accident settlement recoveries to see whether you have to pay income tax on them.
Are Property Damage Settlements Taxable
In almost all cases, no.
Generally, money you receive to pay for repairs to your car, or to compensate you for the car’s actual cash value if it was totaled, is not taxable.
There may be an exception if your totaled vehicle had been used for business purposes and you had claimed depreciation on the vehicle on previous tax returns.
In that case, you would have to allocate the settlement in proportion to the business and personal uses of the vehicle. Depending on the amount of depreciation you had claimed, you might have a gain for business purposes. The personal portion of the settlement would not be taxable.
Are Medical Bill Settlements Taxable
With one exception, no.
Medical bill settlements are only taxable if you receive reimbursement for medical expenses you had previously deducted.
Are Lost Income Settlements Taxable
Just as you would have been taxed on the income if you had earned it, when your lost income is replaced in a settlement, that part of the settlement is taxable.
Are Pain And Suffering Settlements Taxable
Generally, no. But this can be a little tricky depending on the type of injuries you had.
Compensation for physical pain and suffering is not taxable. However, compensation for emotional distress is taxable.
Since a settlement for pain and suffering from a physical injury is not taxable, but compensation for emotional distress is taxable, you may have to pay taxes on any part of your car accident settlement that is for emotional suffering. Examples of emotional suffering are depression, anxiety and post-traumatic stress. However, even in the case of emotional suffering, medical bills incurred to treat the emotional problem are not taxable (unless you previously deducted them).
Are Punitive Damages Settlements Taxable
Although it is rare in car accident cases, if your injuries were caused by intentional and malicious behavior, you might be awarded punitive damages. An example is a road rage incident where another driver intentionally rammed your car.
Punitive damages are not based on your physical pain and suffering (which is not taxable). Instead, they are based on the bad conduct of the person who caused your injuries, and they are taxable.
What If You Receive A Lump Sum Injury Settlement That Does Not Divide The Settlement Bettween Different Kinds Of Damages
If your injury claim is resolved in court, the judge or jury will probably allocate specific amounts to medical bills, lost income and pain and suffering. Therefore, you can determine which parts of the verdict you receive are taxable, if any.
However, if you settle your injury claim out of court, normally the insurance company will just send you a check for the total amount of the settlement. There will be no division of the settlement among medical bills, lost wages and pain and suffering. And while the Release you sign will state that you are waiving further claims for all types of damages, it will not allocate the money to different elements of damages.
What do you do in that case — which is by far the most common situation?
You consult with your tax advisor. That’s why you pay her big bucks, to advise you in situations such as these.