Severance damages in eminent domain are the payment for the loss in value of the land the owner keeps after a partial taking, and for tax purposes they are treated differently from the payment for the land taken: they reduce the basis of the retained parcel first, and no gain is recognized until that basis is used up. That treatment is only available if the allocation between the two is written into the settlement before it closes. Negotiated afterward, it does not exist. In a partial taking this is the most accessible tax planning there is, and its window closes at the signature.
What severance damages are, and why they matter
In a partial taking, the condemning authority pays for two things: the property actually taken, and the damage done to what remains. The second payment, the severance damages, also called damages to the remainder, is where significant tax planning lives. Under the IRS rules, severance damages first reduce the adjusted basis of the retained parcel rather than triggering taxable gain. If the damages received do not exceed the retained parcel’s basis, the owner recognizes no income at all on that part of the award.
For an owner with meaningful basis in the retained parcel this is not a minor point; it can be the difference between a significant tax bill and none on a large share of the proceeds. The arithmetic is simple. Money characterized as severance damages absorbs against basis first. Money characterized as compensation for the property taken flows through the gain calculation immediately.
The condemning authority is typically indifferent to the characterization. Its total payment is the same however the award is divided between the parcel taken and the remainder. That indifference creates an opportunity, and the opportunity expires at closing.
Why the allocation must be negotiated before closing
The IRS position is unambiguous: the allocation between compensation for the property taken and severance damages must be established in writing before the transaction closes. A retroactive allocation, negotiated or documented after the settlement is executed, will not be recognized. The IRS treats the entire undifferentiated payment as proceeds from the property taken, and the full gain calculation applies.
This is not a technicality. The Tax Court has consistently sustained IRS challenges to post-closing allocations, even where the economic argument for a severance characterization was otherwise sound. The allocation has to be in the settlement agreement, not in a later letter or memorandum.
How to approach the negotiation
The condemning authority will often resist a large severance characterization, partly because it implies the project did more harm to the remainder than the authority wants to acknowledge publicly. The practical approach is to document the damage to the retained parcel in concrete terms before final settlement negotiations begin: loss of access, severed utilities, a reduced highest and best use, physical isolation of remaining parcels, or the end of uses that depended on the part taken.
That documentation, ideally supported by an independent assessment of the retained parcel’s value before and after the taking, gives the negotiation a factual foundation rather than a number pulled from the air. Condemning authorities are more likely to accept a severance characterization that rests on something they cannot easily dispute. What the appraisal has to show is the subject of our companion piece on the appraisal evidence the IRS requires for severance.
A word on settlement language
Our practice is to keep the settlement document itself simple. A clear dollar allocation between the property taken and the severance damages is necessary, but we generally advise against loading the settlement with detailed breakdowns, attached appraisals or itemized component lists. Less detail in the formal document preserves flexibility for the owner’s tax team; more detail hands the IRS a roadmap. The analysis and the supporting documents belong in the close-out file, available if needed, not embedded in the agreement.
Practitioner note. The settlement agreement should state the allocation between the property taken and the severance damages in explicit dollar amounts. The IRS requires the allocation in writing before closing; a later letter or memorandum will not substitute. If the owner is still at the negotiating table, this is the conversation to have today. Once the settlement is signed, the window is closed.
When the damages are larger than the basis
If the severance damages exceed the retained parcel’s basis, the excess is gain in the year of receipt, and that gain can itself be deferred under Section 1033 by reinvesting in qualifying replacement property, without restoring the retained parcel. That rule, Rev. Rul. 83-49, is the subject of its own article.
The bottom line
Severance damage planning is one of the most accessible tax strategies available in a partial taking, and it costs nothing to negotiate. The only requirement is that it happen before closing. Attorneys who raise the question early, ideally before settlement negotiations begin in earnest, consistently produce better tax outcomes for their clients than those who surface it afterward.
Where a tax specialist fits
We are not the owner’s attorney and we do not negotiate awards. We calculate the retained parcel’s basis before the allocation is discussed, so the attorney knows how much severance characterization the basis can absorb, and we keep the settlement language simple while the analysis sits in the file. If the owner does not need us, we say so. The first call is free.
Frequently asked questions
Are severance damages taxable? Not at first. They reduce the adjusted basis of the retained parcel. Only the amount above that basis is gain, and that gain may qualify for Section 1033 deferral.
What is a partial taking? A condemnation that takes part of a parcel and leaves the owner with the rest. The award may include compensation for the part taken and severance damages for the loss in value of the remainder.
Can the allocation be fixed after the settlement is signed? No. The IRS requires the allocation to be in writing before closing, and the Tax Court has upheld that position. After signing, the whole payment is treated as proceeds for the property taken.
In a partial taking and still at the table? A free thirty-minute call with Steve Medendorp looks at the allocation before the settlement closes.
