Most personal injury settlement money is not taxable under federal or Texas law — but there are exceptions that can surprise clients who don't understand the rules. Here's what you need to know before you settle your case.
The General Rule: Physical Injury Settlements Are Tax-Free
Under Internal Revenue Code § 104(a)(2), compensatory damages received for personal physical injury or physical sickness are excluded from gross income. This includes: medical expense reimbursement, lost wage compensation, pain and suffering, and most other compensatory damages in a personal injury case.
Important Exceptions: What IS Taxable
- Punitive damages — always taxable as ordinary income
- Interest earned on a settlement from the date of agreement to payment
- Lost profits in a business injury case
- Emotional distress damages NOT associated with a physical injury
- Medical expense reimbursement if you previously deducted those expenses on your taxes
Property Damage Settlements
Property damage recoveries are not taxable up to the cost basis of the property. If you receive more than your basis (e.g., you receive full replacement cost for property you bought years ago at a lower price), the excess may be taxable gain.