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Payments from Legal Settlement are Taxable Income
Unless They're the Result of Personal Physical Injury or Physical Illness

Settlements resulting from a lawsuit can arise for a number of reasons. Since August 21, 1996, all damage awards, including punitive damages, are included in taxable income unless the award was due to personal physical injury or physical sickness.

Note that mental illness or "pain and suffering" awards do not qualify for exemption from tax as they are not considered physical injury or illness.

Damage awards can also be paid as a result of injury to a capital asset. For example, a car careens into your home and causes damage to the structure. You sue the driver and are awarded a settlement. The amount you receive is only taxable if it exceeds the basis in your home. If that’s the case, the excess is reported as a capital gain. In any event, the amount you receive will reduce the basis of your home.

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