Lawsuit Settlement

[LSmith33]

I had an issue come up this year with one of my clients. She bought a brand new house in Spokane, WA for $305,000 in 2005. She invested $21,000 to finish the basement (was unfinished when she bought it) and shortly thereafter she had issues with drainage and flooding and the whole basement was torn apart. She spent another $6,000 in clean up costs and eventually sued the builder and won. She received a settlement of $95,000 in May 2008. She had sold the house at a huge loss ($225,000) in March 2008. (Fully disclosing the drainage issues, which per an engineer she hired, pretty much cannot be fixed.)

My question is the settlement income. I found a very brief publication (#4345) on IRS website discussing the taxability of settlements. In the pub it states that settlements of this nature (Loss-In-Value of property) may be taxable if the settlement exceeds the adjusted basis in the property. I'm confused as to what that basis should be. Would it be the basis in the basement only or the total adjusted basis of the house? I haven't found much else during my research on this matter and thought I would throw it out here for discussion/input. I realize it's the 14th and I don't expect an immediate reply. I have prepared the return using the basement basis only and filed an extension until I can research it further. I'd appreciate any thoughts or directions suggested. I want to make sure that I take the correct position on this.

Thank you.

~Laura J. Smith, EA

Bayberry Accounting & Tax Service

Bellingham, MA 02019

[PapaJoe]

The settlement should relate to the loss in value of the whole house, not just the basement.

[schirallicpa]

I agree. The basement is an intregal part of the house. It may be different if it was a garage, or non-attached building. But the basement is part of the house, and I would consider the entire basis of the house.

[LSmith33]

Thank you both for your input.

[RoyDaleOne]

The settlement reduces the basis in the house. It is a return of capital.

If the house was a personal asset there is a nondeductible loss.