Are Colorado Construction Defect Settlements Taxable?

The first phone call after a settlement check arrives is, surprisingly often, to a CPA. That is the correct instinct. The question of how a construction-defect settlement is taxed is not a legal question I answer in the same breath as the litigation; it is a tax question, and it depends on facts that the litigation file does not always make tidy. What I can do — and what this article is for — is explain the categories well enough that the homeowner walks into the CPA's office with the right paperwork and the right vocabulary.

The short version: a construction-defect settlement is rarely a single tax event. It is a basket of recoveries, and the categories inside the basket are taxed differently. The way the settlement agreement is drafted, and the way the settlement is documented, can move dollars between categories. That is where the legal side and the tax side actually intersect.

The baseline rule, and its big exception

Under Internal Revenue Code § 61, all income from whatever source derived is taxable unless specifically excluded. The leading exclusion in the personal-injury world — § 104(a)(2) — excludes damages received "on account of personal physical injuries or physical sickness." That exclusion is what makes auto-accident bodily-injury settlements tax-free.

A construction-defect settlement is not a personal-physical-injury case. It is, almost always, a property damage and economic-loss case. Section 104(a)(2) generally does not apply. So the baseline assumption — subject to the categorical analysis below — is that construction-defect recoveries are taxable to some degree, and the analysis is about how and how much, not whether.

The four categories

In my experience, four categories cover most construction-defect settlement dollars:

1. Compensation for property damage, up to basis. When a homeowner recovers money that compensates for damage to the home, the IRS treats the recovery first as a return of capital — a reduction in the homeowner's basis in the property — to the extent of basis allocable to the damaged element. Under the "recovery of capital" doctrine, return-of-capital amounts are generally not taxable when received. They reduce basis, which affects the tax on the property's eventual sale.

This is the category where the largest portion of most settlements lands. It is also the category that requires the most documentation, because the homeowner needs records of basis to support the position. In practice, that means closing statements, improvement records, and an itemization of what the settlement is paying for.

2. Compensation for property damage, in excess of basis. Where the recovery exceeds basis allocable to the damaged element, the excess is generally treated as a capital gain. For a long-held primary residence, the homeowner's § 121 home-sale exclusion may absorb some or all of that gain if the property is later sold, but the gain has to be tracked and reported.

3. Compensation for lost rents, delay, interest, and similar items. Where the settlement compensates for lost use of money — pre-judgment interest, lost rents on a rental property, delay damages — those amounts are generally taxable as ordinary income in the year received. Interest is the cleanest case; it follows interest tax treatment regardless of how the underlying claim is characterized.

4. Punitive damages. Punitive damages, where awarded or paid as a separately identified component of a settlement, are taxable as ordinary income. The Supreme Court resolved any residual ambiguity on this in O'Gilvie v. United States and the rule has not softened. In a construction-defect case, punitive damages are unusual but not unheard of, particularly in fraud-flavored claims under the Colorado Consumer Protection Act at C.R.S. § 6-1-105.

The attorney-fee problem

The category that catches the most homeowners by surprise is attorney fees. In Commissioner v. Banks, 543 U.S. 426 (2005), the Supreme Court held that the portion of a recovery paid to a contingent-fee attorney is generally income to the client first, then deductible (or not) as a separate matter. The result, in a contingent-fee construction-defect case, can be a homeowner whose gross taxable amount includes the lawyer's third, even though the homeowner never had the use of that third.

In construction-defect cases where most of the recovery is properly allocable to property damage and within basis, the Banks problem is muted, because the income side is small and the fee allocation tracks. In cases that produce a large ordinary-income or punitive component, the problem is real and a CPA needs to model it before the settlement check is even cashed.

Allocation in the settlement agreement matters

This is the place where the legal drafting affects the tax outcome. A settlement agreement that simply says "$200,000, inclusive of all claims" gives the IRS room to characterize the entire amount any way it likes. A settlement agreement that allocates the payment — so many dollars to property repair, so many to diminution in value, so many to lost rents, so many to attorney fees — gives the homeowner a documentary basis for the categorical treatment described above.

Allocations are not bulletproof. The IRS can challenge them, particularly when they look manufactured. But a reasonable, factually supported allocation that the parties negotiated at arm's length is generally respected, and it gives the homeowner a defensible starting position with their tax return.

Where there is a Form 1099 in the settlement paperwork — and there almost always is — the form's box characterization matters too. A 1099-MISC reporting "other income" creates a different posture than a 1099 reporting interest or a 1099 with a payment in a property-related box. Reviewing 1099 treatment before the settlement closes is one of the cheaper things a tax-aware lawyer can do for a client.

What this means for the homeowner

A homeowner with a settlement on the horizon — or a check already in hand — should be doing three things:

• Document basis. Pull the closing statement, the original construction or purchase contract, and every receipt for capital improvements to the property. Basis is what determines how much of the recovery is tax-free as a return of capital.

• Get the allocation negotiated, not assumed. If the settlement agreement is still in draft, the allocation paragraph is worth specific attention. The lawyer drafting the agreement should be told that the tax treatment matters, because most settlement agreements are drafted with litigation finality in mind rather than tax characterization.

• Bring the documents to a CPA before the return is filed, not after. The categorical analysis is straightforward; the application is fact-specific, and the tax filing positions taken in year one shape what positions can be defended in year two if the IRS asks.

What I can tell a homeowner with certainty is what I told the one who called me last spring with the check already deposited and the tax return in front of her: this is the moment for the CPA, not the lawyer. What I can also tell her is that the homeowner who walked into the CPA's office two days before the return was due, with no allocation and no basis records, paid more tax than the homeowner who walked in two months before, with the settlement agreement, the closing statement, and a folder of improvement receipts. The categories are the same. The outcome is not.