The Non-Taxable Return of Capital

Our tax laws acknowledge that a return of capital doesn’t trigger income tax.

The fundamental concept is that when property is taken away from a taxpayer and then returned to them, it doesn’t result in an increase in their net worth. Rather, their net worth is restored to where it was before, and since there is no increase in net worth, no income tax is due.

Determining whether there has been an increase in net worth can be a challenging task, especially when it comes to proceeds from lawsuit settlements or awards. It’s often difficult to distinguish whether an award is only restoring net worth or increasing it.

The recent case of Herrmann v. Commissioner, Docket No. 13269-21S (USTC 2023), is a prime example of this dilemma. The case involves a mortgage company’s award, and the question at hand is whether the award is taxable income or a reduction to the tax basis in the property.

Facts & Procedural History

The taxpayers in this case are husband and wife. The dispute involves the mortgage on their residence. The taxpayers applied to Bank of America for a modification of their home mortgage loan. Bank of America denied their application and appeal.

The taxpayers then filed a lawsuit in California State Court, alleging that Bank of America had a duty to competently evaluate their loan modification application, which the bank breached by miscalculating their gross monthly income. The taxpayers claimed that this breach caused the improper denial of the loan modification, resulting in higher monthly payments, interest rates, and emotional distress. They amended their complaint multiple times to include other damages such as damage to their credit, increased interest and arrears, foregone alternative remedies and solutions, legal fees and costs, extreme emotional stress, distress, anxiety, depression, insomnia, and the imminent loss of their home. Bank of America eventually settled the case for $18,000.

On their 2018 tax return, the taxpayers did not include the $18,000 settlement amount in their gross income, instead attaching a note that the settlement was offset by a reduction in the basis of their home. The IRS computer matching system no doubt picked up on the discrepancy and, eventually, this resulted in the IRS issuing a notice of deficiency to the taxpayers.

The taxpayers then filed suit in the U.S. Tax Court which was tasked with determining whether the $18,000 settlement award was taxable income or a return of capital because it was for a loss in the value of their property.

General Income Tax Rules

To understand “return of capital” cases, we have to start with the general tax rules.

When it comes to income tax, the general rule is that you start with everything. All income is considered gross income. Then you apply various exclusions that are set out in the tax code.

These rules are the same for settlement awards. You start with the concept that gross income includes all income from whatever source derived unless a specific statutory exception applies. Settlement proceeds constitute gross income unless the taxpayer proves that such proceeds fall within a specific statutory exception. And yes, the courts generally say that the “exclusions” from gross income “must be narrowly construed.”

The “return of capital,” can include a number of different types of capital. The most noteworthy as of late is the return of “human capital.”

Non-Taxable Return of Human Capital

Those who follow tax cases may recall the not-to-distant Murphy v. IRS, 460 F.3d 79 (D.C. Cir. 2006), debacle involving the non-taxable return of “human capital.”

The case involved a settlement for an award for emotional distress or loss of reputation–which is similar to defamation awards. The taxpayer in Murphy argued that a settlement award for physical injury or sickness was simply meant to make her whole and constituted a return of her “human capital.”

The D.C. Circuit Court of Appeals agreed with the taxpayer. It held that an award for emotional distress or loss of reputation is not taxable because it was meant to make the recipient whole, not to compensate them for lost wages or taxable earnings. The court cited historical opinions, including a 1918 Attorney General opinion and a 1922 IRS ruling, to support its decision that compensation for personal injury, including nonphysical injury, should not be considered income. The court concluded that the framers of the Sixteenth Amendment would not have viewed such compensation as income.

After news of the case spread, the appeals court reconsidered its own opinion and reversed itself by vacating its own decision. This seems to have put an end to the concept of a return of “human capital,” forcing those cases into the recovery of physical injury or sickness under Section 104. There have been quite a few other cases involving other types of capital.

Non-Taxable Return of Capital for Corporations

This brings us back to the concept of recovery of non-human capital. This concept is found directly in the tax code for corporations.

Section 301 addresses this. It says that distributions to the shareholders in excess of the earnings and profits (generally the current year earnings), are first a non-taxable return of capital equal to the capital investment and then taxed as capital gains if in excess of that.

There are numerous court cases for this type of return of capital. For example, United States v. Abramson, 18 CR 681 (N.D. Ill. Jan. 25, 2023), a criminal tax case, involved a defendant who was accused of failing to report and pay tax on distributions from his corporation for certain payments made to his girlfriend. The defendant raised a defense that payments made from his corporation to his girlfriend were not income to him, as they were return of capital in the form of a return of loans or capital contributions he made to the entity.

There are scores of other less controversial cases that address this concept in the corporate context–all of which show that return of capital is, in fact, not taxable.

Return of Capital for Tax Basis

The other type of return of capital that is not taxable is the return of tax basis.

Generally, one only pays income tax on the gain on the sale of the property. The gain is computed by taking the sales proceeds less the tax basis in the property. Tax basis is generally the capital investment or outlay to acquire and improve the property.

In the case of real estate, the gain is the proceeds received from the new buyer. This is reduced by closing costs for the sale. Then the tax basis is the original purchase price plus the cost of improvements.

This type of return of basis is also found in the code and well established in our tax laws.

Return of Capital in Settlement Agreements

This brings us to settlement agreements, like in the present case. It is often difficult to tell whether the settlement agreement is really a payment for a return of capital or a payment for a taxable item.

There are quite a few court cases that involve disputes for the return of capital involving settlement agreements. We can glean several rules from these cases.

These court cases stand for the proposition that recovery of capital is not income, and proceeds that represent compensation for lost value or capital are generally not taxable. Whether a payment received in settlement of a claim represents a recovery of capital depends on the nature of the claims that were the basis for the settlement. To determine whether a settlement represents lost value, one has to consider, “in lieu of what was the settlement awarded?”

The nature of the claim is typically determined by looking at the settlement agreement, focusing on the origin and characteristics of the claims settled. Should the underlying agreement not answer the question, one has to inquire as to the intent of the payor, taking into consideration all the facts and circumstances of the case.

An example of this is the Holliday v. Commissioner, T.C. Memo. 2021-69 (2021) case. In that case, the taxpayer filed suit against her divorce attorney for malpractice. She asserted that the settlement award was a recovery of her marital estate and not taxable. The IRS disagreed, as did the court. The court concluded that the payment was a recovery for malpractice and not the recovery of marital property.

The Importance of the Settlement Agreement

This brings us to the current case. The question was whether the $18,000 settlement award was a recovery of the value of the home or damages paid to the taxpayers that were independent of the home itself.

The taxpayers in this case claimed that the Bank of America settlement payment was excludable from gross income because it was for a loss in the value of their property. They relied on IRS Publication 4345 for support. However, the publication only applies to property settlements for a loss in value of the property that is less than the adjusted basis of the property, which is not applicable to the taxpayers’ case.

This is a difficult legal question, as loan costs do get capitalized into the value of the home. This is accomplished by adding the costs to the taxpayer’s tax basis of the home. It would seem that loan recoveries would also be added to the basis of the home.

The court did not provide an answer to the question. It concluded that the taxpayers did not provide a copy of the settlement agreement and, therefore, the court could not fully consider the issue.

The Takeaway

It’s crucial to determine the taxability of settlement awards received. In most cases, settlement awards are taxable unless they are distributions from corporations or a return of tax basis in the sale of property. However, in cases where the awards involve mortgage service providers or other complex scenarios, it’s not always clear whether they are taxable or not. Seeking tax advice from a qualified tax attorney can help individuals navigate these challenging tax situations and avoid potential tax consequences.