Inaja Land Co. v. Commissioner, 9 T.C. 727 (1947)
Jan 18, 2015 by Vahid Dejwakh

Facts and Procedural History

Taxpayer buys land in California for $61K. City of LA digs a tunnel nearby and began diverting water onto his property, which causes him some harm. He sues the city and settles for a $50K award, agreeing to free the city of any further liability and to give the city an easement. He pays $1K in legal fees to recoup this $50K.

Issue(s)

Should we (and if so, how) tax this $49K gain? as capital gains? as income? as compensation for loss? Has he sold part of his land to the government? Three options:
1. Treat all as income. Similar to rent.
2. Allocate basis. Similar to partial sale.(i.e. treat $49K as income, but deduct $49K from his cost basis of the property)
3. No gain or loss. Reduce cost basis.

Holding and Dissent(s)

No gain or loss. Do not tax, because it is capital gains, offset by his cost basis for this gain (i.e. the harm he suffered)
Most favorable outcome to taxpayer. He did this transaction involuntarily, so give him benefit of doubt.

Analysis and Discussion

If he later sold his property, his cost basis would be $61K - $49K (so $12K). The tax treatment takes into account all economic activity resulting from the property. If he sold the property for $20K, he would have net taxable gain of $8K. If he sold for $12K, he would have no gain and no loss. If he sold for $10K, he would have a deductible loss of $2K.

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