What's Taxable, What's Not

Although most of the income you receive during the year is taxable, there are some exceptions. As you tackle your 2010 tax return, here’s a quick rundown of what’s taxable and what’s not.

Generally, tax-free income can be divided into several categories, including canceled debt; certain employer payments; prizes and awards giving for an achievement; gifts and inheritances; insurance claims and life insurance proceeds.

Some examples of tax-free employer benefits include expense account reimbursements; deductible employer-paid moving expenses; qualified adoption assistance and dependent care; fringe benefits for commuting expenses; and up to $5,250 of qualified education assistance.

Other income that is tax-free includes: child support payments, workers’ compensation benefits and welfare payments. Gifts, bequests and inheritances are not taxable. Neither are compensatory damages awarded for physical injury or illness, nor cash rebates from dealers or manufacturers.

Some income is taxable under certain circumstances, but not others. For example:

Life insurance. If you surrender a life insurance policy for cash, you must include in income any proceeds that are more than the cost of the life insurance policy. Life insurance proceeds, which were paid to you because of the insured person’s death, are not taxable (unless the policy was turned over to you for a price as in a life settlement agreement).

Scholarships and awards. If you are a degree candidate, you can exclude amounts you receive as a qualified scholarship or fellowship; amounts used for room and board do not qualify. Prizes or awards given for outstanding educational, literary or civic achievement are not taxed. Prizes and awards won in contests are taxable, as are scholarships given as contest prizes if the recipient is not required to use the prize for education.

Bartering. When you exchange property or services in lieu of cash, the fair market value of the goods and services are fully taxable and must be included as income on Form 1040 of both parties. But an informal exchange of similar services on a noncommercial basis, such as carpooling, is not taxable.

Legal settlements that replace taxable income are taxable, as are damages paid on account of personal injuries that are not physical, such as discrimination, invasion of privacy, libel, slander or defamation. Damages received on account of physical injury or illness, including emotional distress, are not.

Gambling winnings are taxable, but they can be offset by gambling losses if you itemize your deductions.All other items—including income such as wages, salaries, tips and unemployment compensation –are fully taxable and must be included in your income unless specifically excluded by law. For example, some or all of your Social Security benefits may be tax-free, depending on your income.

For a full list of what’s taxable and what’s not, see Publication 525, Taxable and Nontaxable Income or by calling the IRS at 800-TAX-FORM (800-829-3676).