Attorney Fees Deductible or Not?

[Terry D EA]

Client purchased a home on an installment sale agreement (seller financed). Contract drawn up everything legitimate, all payments including interest paid on time. Client purchased this property and rented it out almost  immediately, never lived in the property. Two years into the installment agreement, client wanted to payoff the contract. No early payment language or penalties. Owner who financed refused the payoff. In TY 2020 client hired an attorney and through the courts was able to pay off the property. Because this has been a rental, are the attorney fees deductible? Haven't done any research yet, but was hoping someone here may have experienced this.

The fees, if deductible, would be on Schedule E. Because the IRS has determined rental activity is indeed a business, my first instinct is to say the attorney fees are deductible.

[Terry D EA]

Just to add, and I may have answered my own questions. I did find this on Freshbooks and will look further. Still not sure it it applies 100%. Apparently the guy who financed (seller) the property didn't want to give up the interest.

"Legal fees linked to handling, protecting or maintaining income-producing property are usually tax deductible"

[Patrick Michael]

I would expense it.  Legal costs are a "ordinary and necessary" cost of rental property.  The expense has nothing to do with acquiring or improving the property so no need to capitalize.  No different from deducting the legal costs of evicting a tenet.

[Terry D EA]

Thankyou, those were my thoughts as well. I did question capitalizing it but agree there is no need. 

[Lee B]

I think it falls into a gray area. Is it really related to protecting, preserving and maintaining?

It's really related to reducing interest expenses.

However I acknowledge that most preparers would probably take this deduction.

[Gail in Virginia]

12 minutes ago, cbslee said:

I think it falls into a gray area. Is it really related to protecting, preserving and maintaining?

It's really related to reducing interest expenses.

However I acknowledge that most preparers would probably take this deduction.

Interesting point.  I wonder if you could look at the general requirement for expenses to be in the same period that the income they are related to occurs, and argue that in this case the legal fees should be amortized over the period of time that the interest expense would have been taken had they not paid the loan early based on the court decision?  I think, unless it is large amount for  legal fees, that I would just expense it but I certainly see your point. 

[jklcpa]

You have to look at the underlying reason why the expense was incurred.  The legal fee is directly related to the financing and not for protecting, preserving, or maintaining the asset itself, and not for production or collection of related income.  It was incurred to save on the outlay of interest expense, but is that enough to be considered ordinary and necessary in the operation of this rental activity?  Unless it is a nominal amount such as would be charged for the attorney to write a letter to the other party, I would probably capitalize.

Caveat - my opinion, not researched.

[Lee B]

Gaill & Judy,

Good points. The attorney fees are like the costs associated with refinancing.

[Max W]

HUD has rules for making pre-payment.  If they are not followed the loan holder can refuse the payment.

The 2 main rules are; 1.) the mortgagor has to send a 30 day notice of the intention to prepay.; 2.) the pre-payment has to be made by the due date of the next payment and include any interest.

https://www.hud.gov/sites/documents/43301C5HSGH.PDF

 

[DANRVAN]

On 5/1/2021 at 10:44 AM, cbslee said:

I think it falls into a gray area.

I agree.

You have to look at the "origin of claim test" to determine if the legal cost are related to the capital asset or operational expenses.

I believe a case could be made that by reducing the amount of interest paid, the taxpayer is attempting to cut  expenses and increase the profitability of the activity.  In that case, the origin of claim goes to back to operational expenses and is currently deducted.

If on the other hand the legal fees were incurred to defend the title of the property, the origin would be capital in nature.

On 5/1/2021 at 6:19 AM, Terry D said:

protecting or maintaining income-producing property are usually tax deductible"

That quote sounds like it was  made in reference to section 212,  which basically applies to investment expenses which are itemized deductions currently suspended by TCJA.

[Terry D EA]

The attorney fees in this case were approximately $1100.00. Not looking at the return at this moment. If the HUD pre-payment rules were not met, why did the court rule in my client's favor? i agree this all falls in a gray area. I am going to expense the fees as they are not a large amount. I don't know all the details surrounding the court ruling. I definitely agree this is not for maintaining the integrity of the rental property. But, it could fall under the course of normal business type expense. I am meeting with the client tomorrow to review the return so hopefully we can have some insightful conversation about this.

[Lee B]

It appears that this is a standard passive income  rental in which case none of the expenses are "normal" business expenses.