Interest on Eminent Domain Settlement Is Tax Free

When a property owner receives a settlement from the government for taking his property under eminent domain, the settlement may be paid out over time, with interest on the installments. In one recent case, taxpayers who received such interest excluded it from gross income, reasoning that it was tax-exempt interest just like interest paid on a municipal bond. The Tax Court disagreed, but now an appellate court has ruled in favor of the taxpayers.

The interest on the installments was a state obligation and therefore was tax free. The interest arose as a result of bargaining between the property owners and the state (Pennsylvania in this case), which triggered the state’s borrowing power. However, the court pointed out that not all interest paid by a state is automatically tax exempt; it just happened to be tax exempt under the facts of this case.