@ChrisPD wrote:
Robert,
I've read several of the recommendations on how to report the gain or loss on a cash and keep lemon law settlement and I'm still not certain on how the gain/loss works. Some of the posts contradict each other on their advice. I was awarded a settlement under the state Lemon Law whereby I was awarded $40k (including legal fees) on a vehicle with an original FMV = $46k. Some of the advice in this blog recommends reporting the gain as a difference between the original purchase price $46k and the FMV at the time of the settlement which was about $19K. The way I understood it, the taxable amount would be the difference between the settlement of $40k and the net loss on the value of the vehicle ($46k original FMV - $19k FMV at time of settlement = $27k loss), so $40k settlement - $27k loss in value = $13k taxable income. Would this be correct?
FMV is not relevant. What counts is your adjusted cost basis.
Example 1. This is a personal vehicle, never used for business. You paid $46K. The lemon law settlement is $40K (use the total, don't split out the fees). This reduces your adjusted cost basis to $6K. Then, sometime in the future, you sell the car as a used car for $8K. Now, you have a $2000 capital gain, because the selling price is more than your adjusted cost basis. (Most people who sell used cars don't have a capital gain because they sell for less than their cost basis, but here your cost basis is reduced by the settlement.)
Note that if you were to consider the settlement as (for example) $30K for the car and $10K for legal fees, the adjustment to the basis is $30K and the $10K in legal fees is miscellaneous other income. Since there is no tax deduction for personal legal fees that you pay, there's nothing to offset that taxable income and you pay tax on it. So it's better to treat the entire payment as towards the car's cost basis.
Example 2. This is a personal vehicle also used for your schedule C sole proprietorship, and you have taken mileage deductions for 30,000 business miles using the standard rate. The depreciation built in to the standard mileage rate is about 25 cents per mile (it varies), so you have $7,500 of depreciation to account for, your adjusted cost basis in the car is now $38.5K. With a $40K lemon law settlement, your cost basis is reduced to zero and you have a $1500 taxable capital gain now. Later, if you sell the car used for $8,000, the entire selling price will be capital gain since the adjusted cost basis at the time of the sale is zero.
