14.2 Return of Capital or Property Damage

Compensation for property damage or breach of contract by a home improvement contractor is not income unless it exceeds the basis in the property.1  No economic gain results from a recovery of basis in a capital asset. I.R.C. § 1016(a)(1) provides that a proper adjustment shall be made for receipts and expenditures properly chargeable to the capital account of the damaged property. The homeowner should reduce the home’s basis by the recovery and then increase it by the costs incurred for repairs or restoration.

Recovery of attorney fees may trigger income tax liability unless the recovery is excluded from income, deductible, or chargeable to the capital account of an asset. A recovery of attorney fees for damage to a home should be tax neutral. Such attorney fees should be capitalized rather than deducted. Adjustments to the home’s basis from recovery and payment of attorney fees should offset each other, resulting in no immediate or deferred recognition of income.

• 1Rev. Rul. 81-277, 1981-2 C.B. 14; Daugherty v. Comm’r, 78 T.C. 623 (1982); see also GCM PRENO 111606-07 (May 18, 2007) (addressing tax issues in Hurricane Katrina and Murphy Oil Spill litigation).