Insurance settlements can often be in the thousands of dollars, which can result in a substantial tax liability for you if you aren't careful. Some settlements are tax-free, but others aren't. While general rules can help you determine the likelihood of taxes on your award, your best option is to consult an accountant or other tax professional to make sure.
Type of Insurance
Some types of insurance settlements are always considered taxable income. Others are only taxable under certain circumstances. Life insurance benefits, for example, are not taxable under normal circumstances. If you receive more money than the face amount of the policy, such as when the insurance company pays you interest on the benefit, you may owe taxes on the excess. Property insurance settlements are also not usually taxable, though they can be.
Personal Injury Settlements
The Small Business Job Protection Act of 1996 defines the rules of personal injury settlement cases, as of April 2011. Liability insurance often contains coverage for personal injuries, such as emotional distress, harassment and pain and suffering. Since 1996, all personal injury settlements are taxable unless they meet two criteria. To be tax-exempt, there must be a physical injury, and the award must be the result of a tort, or wrongful act. The rules that govern these criteria can be blurry, so consult an accountant, attorney or both if you receive a personal injury award.
Property insurance is generally supposed to restore your insured property to its pre-loss condition without resulting in a financial gain for you. Often, as with auto insurance, the maximum benefit you can receive is the actual value of the property. Because property tends to depreciate in value, many people never receive more from a settlement than they invested in the property in the first place, and therefore there is no financial gain for the government to tax. If, however, you paid $150,000 for your home but received a $175,000 settlement, you could potentially owe taxes on the $25,000 that exceeds your initial investment, or cost basis, in the property.
Even if you receive enough money to have a financial gain from a property insurance settlement, you can typically avoid taxation by reinvesting the proceeds into the property. For example, if you use all the money from a home insurance settlement to repair your home, the government generally considers that an indemnity payment, meaning you simply restored your property from its damage. Your accountant can help you determine the best use of your settlement money.