Where a taxpayer receives payments for losses, damages, adjustment of purchase price, etc., for a capital asset (Sec 1221), those payments are not taxable to the extent the basis of the capital asset can be reduced (IRC Sec 1016(a)(1)). However the basis can only be reduced to zero and any amount in excess would represent a capital gain.
Reg. Sec. 1.1016-2(a) - The cost or other basis shall be properly adjusted for any expenditure, receipt, loss, or other item, properly chargeable to capital account, including the cost of improvements and betterments made to the property.
Where a contractor was required to reimburse condominium owners due to construction defects to the common elements of the development, the award represented a recovery of capital that reduces the individual unit owners' bases (Rev. Rul. 81-152).
"It is well established that a sum received in settlement based upon a claim of loss of business profits constitutes taxable income but where the settlement represents damage for lost capital rather than for lost profit, the money received may be a return of capital" (Rev. Rul. 73-161).