Legal fees from on-going lawsuit regarding a failed rental property acquisition

[leogrim]

I attempted to purchase a rental property in Europe but had to abandon the transaction after I was unable to secure financing (banks unexpectedly tightened rules for expats). The seller claimed I didn't act in good faith and asked for my deposit and punitive damages. I was advised to defend myself as such demands are seemingly opportunistic & abusive.  An on-going lawsuit will eventually settle the dispute, with the possibility of either party receiving compensation. 

How should I account for the attorney fees I already paid in 2021? Can I immediately claim a business capital loss or should I wait for the lawsuit to conclude? If the latter, should I then capitalize the operation's net outcome (legal fees + potential capital losses + potential damages paid - potential damages received)? 

Thanks for your help 🙏

[JohnB5677]

You can deduct expenses of resolving tax issues relating to profit or loss from business reported on Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship), from rentals or royalties reported on Schedule E (Form 1040), Supplemental Income, and Loss, or from farm income and expenses reported on Schedule F (Form 1040)  

Page 5 Legal Expenses   IRS Publication 529, Miscellaneous Deduction

• In general, legal fees that are related to your business, including rental properties, can be deductions. This is true even if you didn't win the legal case in which the legal fees were incurred.
• You can not claim the capital loss until the litigation is finished. A down payment is not an expense used in operating the property. The down payment is equity in the property.  
• When a party involved in a lawsuit makes a payment pursuant to a judgment or binding settlement agreement, the payment may be included in the recipient's income and may be deductible from the payor's income.  Therefore, you will not have to capitalize any of it.  The amount returned would be a return of capital, and a loss would be a capital loss.

[leogrim]

Thanks so much for the clear answer John! In that case can I use Schedule E to report legal expenses and/or capital losses for a property I have never owned? Or should they be reported via some other form?

[PatriciaV]

If this failed property acquisition relates to an existing real estate business, then you may report the legal fees on Schedule E for that business.

However, if this was a new venture (not an existing business), you may wish to review this TurboTax article to determine if these expenses are deductible: Can I deduct legal fees on my taxes?

Personal legal expenses relating to real estate purchases are not generally deductible.

See also: IRS Pub 529 Legal Expenses

[leogrim]

Thanks for your response Patricia. I'm not sure how to understand "existing real estate business". I currently own several rental properties as an individual and I report income from each of them on schedule E. The failed real estate transaction aimed to acquire another rental property, but there's no real-estate business "entity" associated with that transaction (or with any of my other rental properties, which are all in Europe).

So my current understanding of the law aligns with John's description above (these legal fees are business expenses related to rental properties, not personal expenses) though I'm not sure how/where to report them in TurboTax (since I was never able to acquire the specific rental property those fees are associated with, which is also the very reason I'm incurring those fees in the first place).

Does this make sense?