Most people who receive legal settlements face taxes on those settlements, even when the settlements involve fire-related losses. Fire victims may be surprised by this and think it is unfair.
A federal tax bill and a California tax bill have been proposed which might lead to some recoveries in wildfire lawsuits being exempt from taxes. It isn’t clear if these bills will be passed, but a lot of tax bills are introduced without ever passing.
Congressmen Mike Thompson (D – Calif) and Doug LaMalfa (R – Calif) introduced a federal bill, HR 7305. This bill would have established an attorney fee deduction regarding some wildfire damages, as well as make it so settlement funds relating to attorney fees do not count as gross income. However, the bill failed to pass.
H.R. 176 has now been proposed as a replacement bill.
California bill AB 1249 would provide a similar exemption regarding state taxes and specific wildfires.
However, until both of these bills are written into law, if they ever are, wildfire victims need to take wildfire settlements into account when doing their taxes.
Wildfire victims won’t have to pay taxes on every penny of wildfire settlements. In fact, zero percent of some recoveries will be subject to taxes right now. However, one must be considerably clever to turn a gross settlement amount into a strategy for reporting taxes that will be OK with the IRS and California’s Franchise Tax Board. Fire victims need to consider the entire settlement, including any attorney fees.
Most wildfire victims who file lawsuits are represented by contingency fee lawyers, who don’t charge a fee until and unless a recovery is obtained. While these fees are paid separately to lawyers, they are still considered income for the plaintiff, and thus the plaintiff needs to pay taxes on them.
Legal fees were usually tax deductible until 2018, but the Tax Cuts and Jobs Act changed that in late 2017. Most legal fees are considered miscellaneous itemized deductions, and these deductions were done away with for 2018 through 2025. Because of this, some plaintiffs might not be able to deduct attorney fees. Lawyers must also pay taxes on these fees, and some argue this constitutes double taxation.
California wildfire victims, however, typically have a good way of deducting or offsetting legal fees when it comes to federal and state taxes. Fire recoveries which can be treated as capital gains – most can – involve legal fees which can be considered additional basis in a home or a selling expense, mitigating the way the new law treats legal fees. This basically means only paying tax on any net recovery. Numerous tax issues remain after this, though, and the taxes wildfire victims will need to pay on any recovery depends on their individual circumstances, how much they ultimately recover, and what things they claim on taxes. While federal and state taxes need to be filed every year, wildfires can involve multiple tax years.
Say you lost a $1.5 million home, and you recover $1.5 million from PG&E or your insurance company. You might think there’s no taxes involved since you lost $1.5 million and recovered the same. However, what’s important is your tax basis in your property. This typically means the price of purchase with the costs of any improvements done to it added on. Depreciation, as well as depreciation recapture, need to be factored in regarding commercial properties.
Basis matters, even with homes. The property may be worth $1.5 million at the time of its destruction, but if the price you purchased it at plus any improvements totals only $500,000, then there is a gain of $1 million. You don’t necessarily need to pay taxes on the $1 million in this case, though. Tax laws might consider this an involuntary conversion, and you may qualify to apply the old $500,000 tax basis to a new home. This means you shouldn’t have to pay taxes on that $1 million gain until you sell the new home. For this to occur like this, you must usually buy the new property within two years after the end of the first year in which you realized any casualty gain. This period will be extended to four years with regards to Federal Declared Disasters.
You must also be aware of insurance recoveries which you may receive before you receive any settlement in a lawsuit. The countdown to acquire a replacement property might have already begun if you have been paid money by your insurance company which creates any taxable gain on the property that was destroyed.
Claiming casualty losses can be an issue; taxpayers could do this on tax returns until 2018. However, from 2018 through 2025, you can only claim casualty losses for fires considered a Federal Declared Disaster. Most major wildfires in California are declared Federal Declared Disasters, but it can still take some cautious projection and planning to figure out if it’s a good move to claim a loss.
Expenses for temporary housing, as well as similar expenses, can also be a complex issue. Parts of any insurance money compensating you for living expenses when your primary home is destroyed or damaged might be tax-free, such as food and replacement housing. However, insurance money that compensates you for living expenses that you would typically spend even if your home wasn’t damaged, such as typical food expenses or mortgage payments, might be considered taxable income. Insurance money in excess of what you spend on food, temporary housing or any other living expenses may also be taxed.
While insurance money can create many tax issues, more issues are created when lawsuit recoveries occur, and these issues can be very complex. Wrongful death is involved in some wildfire cases, and damages for wrongful death are not taxed. Punitive damages, however, are always taxed. Physical sickness or physical injuries caused or made worse by a wildfire, such as issues caused by smoke inhalation, are not taxed. Damages for emotional distress are typically taxed, except when the emotional distress is caused by physical injury or sickness.
Damage to or destruction of a property is usually the biggest item in a wildfire case, and this can involve multiple facets, such as a home, crops, shrubs, trees, outbuildings and more. The actions of any taxpayer must also be considered. Are you moving away or rebuilding? You might have a large capital gain if you don’t reinvest, and this gain will be subject to claiming a primary residence tax benefit of up to $500,000 when you qualify. If you sell your primary residence and you qualify, the first $500,000 of any gain for married couples who file jointly shouldn’t be taxed. The balance, however, should be taxable as capital gain. This is regarding federal taxes. In terms of California taxes, all income is taxable up to 13.3 percent.
Many wildfire victims hope they won’t face any taxes when they collect financial compensation from PG&E, Edison or an insurance company. If they are moving proceeds into the purchase of a new home or efforts to rebuild, they might end up with a small basis in a new home, but this means paying taxes later on when the new home is sold. However, there can be surprising examples of taxable money in wildfire cases that you need to be aware of. You need to give details and timing a lot of attention when it comes to wildfire recoveries.
Jeffrey Nadrich
Jeffrey Nadrich is a nationally-recognized California plaintiff’s personal injury attorney. He is a graduate of UC Berkeley and UC Hastings College of the Law. He has successfully represented thousands of injury clients over the last 40 years.
