Making Up the Difference?

A plaintiff purchases a new residential home from a builder, but construction defects are so pervasive that the only economical recourse is to demolish and rebuild the home. The home’s original contract price was $500,000, but costs to rebuild are $750,000. As such, the prevailing plaintiff would realize a gain of $250,000.

Under the current tax code, the realized gain may be considered taxable income and the plaintiff would pay taxes on the $250,000—leaving the plaintiff short of the full $250,000 and placing him in a worse position than if the contract had not been breached.

For ease of reference, assume the $250,000 is taxed at 35%, given the plaintiff’s tax bracket. To offset the taxes, the plaintiff would assert $184,000 in addition to the $250,000 (for a total of $434,000) so that the taxes can be paid and the plaintiff receives the $250,000. Tax neutralization damages are “an increase in the damage award to offset the taxes that will be payable on the award.” [Sonoma Apartment Assocs. v. United States, 939 F3d 1293, 1298 (Fed. Cir. 2019)].

In light of a potential tax bill, can a plaintiff argue for an increase in the damage award to offset the tax liability? The issue is one of first impression in Florida, and may be answered in Grammer v. J.H. Hinson Builders, LLC, et. al., Case No. 2015-CA-001065, pending in the Circuit Court of the First Judicial Circuit of Escambia County.

Courts have awarded additional amounts to judgments to account for the tax liability in other instances. Currently, tax neutralization damages for lost wages, back pay, and Title VII employment cases are recognized. [See e.g. Clemens v. CenturyLink, Inc. 2017 WL 5013661 (9th Cir. 2017), which granted tax neutralization damages since the back pay was made in a lump sum]. Generally, the federal courts have discretion in awarding tax neutralization and apply it on a case-by-case basis.

The premise in most construction-defect cases asserting contract-based claims is to seek damages that would place the injured party in the same position as if the contract not been breached. In Grossman Holdings, Ltd. v. Hourihan, 414 So. 2d 1037, the Florida Supreme Court cited and adopted subsection 346(a)(1) of the “1st Restatement of Contracts,” and stated its ruling is “designed to restore the injured party to the condition he would have been in if the contract had been performed.” A court can use tools, such as the Economic Waste Doctrine, to modify the award of damages so that a prevailing party does not receive a windfall or be in a position better than it would have been had the contract been completed.

Florida recognizes that damages do not require precise calculation, but a party must establish a reasonable basis to support its damages. [See generally Centex-Rooney Construction Co. v. Martin County, 706 So.2d 20 (Fla. 4th DCA 1998); Servpro Industries, Inc. v. Spohn, 638 So.2d 1001 (Fla. 4th DCA 1994)]. Opponents of tax neutralization in construction-defect claims may argue that tax liability will be too difficult to ascertain with certainty, while, on the other hand, a salaried government employee’s tax liability may be stable.

With regard to multi-family, high-rise condominium buildings, or commercial buildings, tax liability from judgments can be offset through business expenditures and tax neutralization may not be a necessary component for damages, but that does not mean a party will not demand tax neutralization damages. In Florida and Texas, there is a cottage industry where individual homeowners in single-family-home developments file suit against large builders and tax consequences may cause demands for tax neutralization damages since the plaintiff is usually an individual. At a minimum, tax neutralization damages will be weaponized in construction-defect cases as leverage during negotiations. 

In Grammer, the court will permit the plaintiffs to present evidence to support their claim for tax neutralization, but reserved ruling on whether the court will award tax neutralization. Importantly, whatever the trial court decides on the application of tax neutralization, the losing party will likely appeal to the First District Court of Appeals. The First District’s ruling will have wide implications in Florida because, under Pardo v. State, 596 So.2d 665 (Fla. 1992), a district court of appeals opinion is binding on all Florida trial courts if the matter is one of first impression.

Finally, an important consideration is whether tax neutralization would be covered under an insurance policy when the underlaying complaint also includes allegations based in negligence causing damage to other property. Insurers often engage in settlements to protect their insured that include resolution of contract-based claims. Further, some policies cover pre- and post-judgment interest if entered against the insured, and questions will arise as to whether tax neutralization damages will be similarly considered.