attys fees for construction defects

Technical topics regarding tax preparation.
#1
JAD  
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Client is suing builder for construction defects. Costs of suit are being capitalized. I have not found guidance on the treatment of those costs once suit is settled. I think that the costs of the suit plus the net costs paid by my client should be depreciated over 39.5 years. I think that depreciation should not begin until the lawsuit is settled, because it is possible that client will be reimbursed for all fees. Agree? Disagree?

Thanks for any direction.
 

#2
Noobie  
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Why would legal fees be capitalized in a lawsuit? Especially for 39.5 years.

I get the fact that the client's expenses to fix the construction defects would be capitalized, and any recovery of said costs would be a partial disposal of said capitalized defect amelioration costs.
 

#3
JAD  
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Why would legal fees be capitalized in a lawsuit?

What else would you do with legal fees incurred related to the construction of a building? Do you see any other treatment under origin of claim concepts?
 

#4
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https://www.thetaxadviser.com/issues/20 ... duals.html

See example 6.

Challenge to title is capitalizable.
Challenge to sales price is capitalizable.
Both deal with actual or possible disposition of the asset.

Purchase legal fees are capitalizable.
Perfection of title legal fees are capitalizable.
Both deal with purchase of asset.

The legal fees you are talking about are not during or part of ongoing construction, but part of a dispute over finished construction. I would argue that they are they are therefore not capitalizable.

Was the imperfections in construction left in the cost of the building. EX: if the floors installed were defective, was that portion of the costs left in the capital account, or removed as a disposition of property?
 

#5
JAD  
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Annette's article is excellent, isn't it? It is almost always where I go to refresh on the issues whenever I have a treatment of legal fee issue.

I disagree with your conclusion that the costs I'm discussing are 212 costs. Here are the examples you referenced:

Example 5: E incurred legal fees in at-tempting to recover damages from a rug-cleaning business that damaged the carpets in her personal residence. The origin of the claim is the maintenance of E’s personal residence, and therefore the fees are not deductible.

Example 6: The facts are the same as in Example 5, except that the residence is rental property. The origin of the claim is now management and maintenance of property held for investment and deductible under Sec. 212.11


Example 6 - origin of the claim is the maintenance of the rental property, which is why the legal fees are 212 expenses. The origin of the claim is maintenance because the damage was due to the cleaning of the rugs. Cleaning is an expense of maintaining the property. What I've posted about is entirely different.
 

#6
Chay  
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JAD wrote:Client is suing builder for construction defects. Costs of suit are being capitalized. I have not found guidance on the treatment of those costs once suit is settled. I think that the costs of the suit plus the net costs paid by my client should be depreciated over 39.5 years. I think that depreciation should not begin until the lawsuit is settled, because it is possible that client will be reimbursed for all fees. Agree? Disagree?

I agree with your position on the fees being capital in nature. I concur with holding off on the "placed in service" date, but I think my reasoning is different from yours.

I don't think a potential future reimbursement is the issue. The fees are your client's expenses in the present absent compelling evidence to the contrary, such as the pre-existence of a reimbursement arrangement (e.g., an accountable plan). Rather, I think the placed in service date would depend on whether the purpose of the suit is to get the defects corrected or to recover money already expended in correcting the defects. If the former, we would wait until the correction is complete to place it in service, at which point the net cost to the taxpayer (if any) would be depreciated. If the latter, we would wait to see what money is recovered and treat the amount in excess of the legal fees as a return of capital on the corrections, which we would have already placed in service at that point. If there is no excess, then the net expenditure would revert to being treated as incurred with respect to the corrections and thus be placed in service at that time.

In the event that the fees are for the purpose of correcting the defects, perhaps your client can avoid capitalization using the de minimis safe harbor election?
 

#7
JAD  
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Thanks for the reply.

Purpose of the suit is to get the defects corrected. The work has not yet been done. Legal fees are way in excess of DMSH. Do I understand that you think that atty’s fees would become part of depreciable basis once construction is done and the asset is placed in service?

My thoughts:

Attorney’s fees: $40,000
Construction costs: $300,000
Settlement: $240,000

Capitalize $100,000, begin depreciating over 39.5 years when correction work is complete.
Claim partial disposition on portion of building that was replaced in correction work.
 

#8
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JAD wrote:Thanks for the reply.

Purpose of the suit is to get the defects corrected. The work has not yet been done. Legal fees are way in excess of DMSH. Do I understand that you think that atty’s fees would become part of depreciable basis once construction is done and the asset is placed in service?

My thoughts:

Attorney’s fees: $40,000
Construction costs: $300,000
Settlement: $240,000

Capitalize $100,000, begin depreciating over 39.5 years when correction work is complete.
Claim partial disposition on portion of building that was replaced in correction work.


In accounting and taxation we make judgement calls. I agree with your judgement call at first glance. What type of property is this?
 

#9
JAD  
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Commercial rental
 

#10
Chay  
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JAD wrote:Do I understand that you think that atty’s fees would become part of depreciable basis once construction is done and the asset is placed in service?
[...]
Capitalize $100,000, begin depreciating over 39.5 years when correction work is complete.
Claim partial disposition on portion of building that was replaced in correction work.

Based on this, it sounds like the entire building has not yet been offered for rent? If this is true, perhaps your client is still in the pre-opening phase and would be unable to deduct a business loss from the partial disposition of property? Also, I wonder...would a loss under section 165 be considered an amount "paid or incurred" for purposes of section 195?

And I think you meant "39 years".

Otherwise, I agree with your position.
 

#11
JAD  
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Building is being rented.

Yes, 39 years. Honestly, who thought that a full number was good for the life of commercial, but a decimal point was needed for residential life? Thanks.
 


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