Deductibility of Legal Fees in a Divorce

Legal fees may or may not be deductible; it depends on the legal action they relate to. Take the following case involving the divorce of Doris Day’s son, Terence Melcher, from his first wife. The marriage was dissolved in 1998 but it took years to settle disputes over property. A family court in California determined their respective separate and community property interests. In particular, the family court ruled that a valuable ocean front property in Martha’s Vineyard that the ex-wife had owned before the marriage but which was put into joint ownership during the marriage was community property that should be sold and the proceeds divided between them, subject to a separate $800,000 interest for the ex-wife. The family court also denied the ex-wife’s claim for spousal support. When the family court accepted a third party’s offer in 2001 to buy the Martha’s Vineyard property for $12 million, the ex-wife vehemently objected. She brought four separate appeals to the family court’s ruling and filed for bankruptcy to get an automatic “stay” on the sale of the Martha’s Vineyard property, the rental income from which was her primary support.

The wife’s appeals were not resolved until 2006 when the California appellate court affirmed all of the family court’s ruling. In 2004, during the appellate proceedings, Melcher incurred legal fees of $201,973. He also incurred legal fees of $72,887 in 2004 to protect his interests in the bankruptcy proceeding brought by his ex-wife. More specifically, he sought to collect $1 million in rents from the Martha’s Vineyard property and the family residence during the bankruptcy proceeding. Melcher deducted the $201,973 and $72,887 in legal fees.

For tax deduction purposes, the origin of the claim determines whether legal fees are deductible. Legal fees relating to purely personal matters, such as the termination of a marriage, are not deductible. If the fees relate to the production or collection of income, they generally may be claimed as a miscellaneous itemized deduction subject to the 2% of AGI floor. However, not all legal fees related to investments and income-producing property are deductible. Fees are not deductible in these situations:

✓ Fees incurred for acquisition of property (they are added to the basis of the property).

✓ Fees incurred for disposition of property (they are subtracted from the sale price and not separately deducted).

✓ Fees incurred to defend title to property (they are added to the basis of the property).

In this case, none of the fees related to defending the property settlement in the appeals brought by the wife were deductible. The fees involved in defending against the wife’s claims for spousal support arose from the marriage and thus are personal expenses. Even though property and potential income are involved in a divorce settlement, the courts have concluded that if the claim would not have existed but for the marriage relationship, then the claim is a personal one and attorney’s fees related the claim are nondeductible. The legal fees incurred by Melcher to defend his interest in the Martha’s Vineyard property were not within the “but-for-marriage” category, because Melcher’s joint ownership interest did not stem entirely from the marriage, as it was obtained when he invested in the property by taking out a mortgage to construct a residence on the property. Nevertheless, the legal fees incurred to defend his ownership interest were not deductible. As expenses incurred to defend title, they must be capitalized and added to his basis for the property.

However, the fees incurred to collect the rents on the properties during the bankruptcy proceedings were deductible. The fees incurred to facilitate the sale of the Martha’s Vineyard property were non-deductible capital expenses, to be subtracted from the sales price. It was not clear how much of the fees were expended for each purposes, so the court allocated the fees, holding that one-sixth of the total fees of $72,887, or $12,147, was expended to collect rent and was deductible.

Your Income Tax, 19.17

Estate of Terence P. Melcher et al., TC Memo 2009-2010

J. K. Lasser’s TM Monthly Tax Letter

October 2009

Volume 19

Number 10