In the wake of the Gulf oil spill taxes may be the farthest thing from your mind, but it’s best to start planning now and avoid a surprise expense at tax time. The IRS recently announced that some oil spill damage payments received from British Petroleum (BP) are taxable. Mississippi and Alabama have both released similar statements. In both states, whether the payment is taxable or not depends on the nature of the damages you are being compensated for.
Damage Payments for Lost Income
Many people have received payments from BP for lost wages or lost business income caused by the oil. Maybe you own a shrimp boat and were unable to operate, or you own a hotel or restaurant that lost customers because of a drop in tourism. Any payments received from BP for these types of damages are taxable because they are in lieu of taxable income that would have otherwise been received (and taxed).
Damage Payments for Loss of Property Value
Payments received for damages due to a drop in property value are not taxed as current income unless the payment exceeds the cost basis of the property. However, these damages will affect the capital gain you recognize if you sell the property later.
Both Mississippi and Alabama require that you reduce your cost basis in the property by the amount of the BP payment you receive. If you sell this property later, this could increase the capital gain you have to recognize.
For example, say you purchased land for $150,000 in 2008, which would give you a cost basis of $150,000. Then you received $30,000 from BP for damages to your property value caused by the gulf oil spill. You would have to reduce your cost basis by this amount for a new cost basis of $120,000 ($150,000 - $30,000). Then let’s say you sell the land in 2011 for $125,000. In this situation, you would recognize a capital gain of $5,000 ($125,000 selling price - $120,000 cost basis). A gain on the sale of your primary residence can be excluded if you meet certain requirements.
Damage Payments for Illness or Injury
Any payments received for physical injuries or sicknesses are generally not required to be reported in gross income since they would not have otherwise been taxable (in the same way an insurance payment would not be taxable). On the other hand, payments received for emotional distress not caused by physical injuries or sickness must be included in gross income.
Deductions for Losses Due to the Oil Spill
A casualty loss results from damage or destruction to property because of a "sudden, unexpected, and unusual" event. In Alabama and Mississippi, casualty losses caused by the Gulf oil spill can be deducted if they are greater than any amounts you received, or reasonably expect to receive, from BP or your insurance company. For example, if you sustained $60,000 in property damage as a result of the oil spill, and received $40,000 from BP, your deduction would be limited to the remaining $20,000 of loss ($60,000 - $40,000).