Lemon law settlement taxable?

[ReneeM7122]

The Fair Market Value of the lemon at the time of the sale is the price you actually paid for it.

@pjcremeens

[Neppi]

My lemon law case was handled by an attorney. My settlement included actual damages for the car plus additional damages. My attorney got paid 45% of the additional damages.  How do I report the additional damages and deduct my attorney fees?  Do i just include attorneys in the negative part?  

My attorney says additional damages from Lemon Law can be considered Civil Rights and thus exempt from taxes.  If that is true, how do i represent that?

[KrisD15]

You should have received a 1099-MISC from the attorney. 

Please enter that under "Income" 

Other Common Income

Income from Form 1099-MISC

Be sure to select "This was money from a lawsuit settlement" on the "Does one of these uncommon situations apply?" screen 

No, that is not completely true. The settlement will be free from Self-Employment tax (or FICA TAX) but will be taxable income as far as Income tax is concerned. 

Additionally, unless the lawsuit is related to your business, the attorney fees cannot be deducted. 

Yep, you pay tax on the income your attorney took. 

According to the IRS:

"Generally, individuals, as cash basis taxpayers, may deduct attorneys‟ fees in the year they are paid, assuming the attorneys‟ fees otherwise qualify as deductible"

This means, if they are allowed to be deducted, you can deduct them. 

But they aren't, unless you are Self-Employed. 

(There was a time when a Taxpayer could possible deduct these fees, but not for tax year 2021)

IRS LINK

[chriswhitesmith]

I have the same situation and am wondering how would anyone know the FMV of the "lemon" at the time they bought it.  Bought for 38k.  Lemon law settlement was 65k which included paying off my loan.  What is my loss/taxable amount?  Never received a 1099. The fogginess of this subject is maddening.  I've been everywhere trying to figure out how you know the FMV of a lemon when you bought it (assuming it's impaired when you buy it).  If it's unusable then it's -0- and my loss is $38k - but if they paid off the loan, then how am I at a loss?  SO confusing

[LeonardS]

Yes, it is a foggy subject.  From what you posted you paid 38K for the vehicle and received 65K as a settlement part of which paid off your loan.  Presuming your loan payoff was 38K you would have  27K remaining.  You actually do not have a loss the settlement paid off your loan and you still had leftover cash from the settlement.

[STC3]

does anyone know, ( I used my SUV for section 179 deduction and now the car's company want to buy back my SUV due to lemon law, what should I do now for last year (2021) tax deduction?     will I need to pay back all the deduction amounts? that is over 25K payment to IRS.

I got the SUV for 89k and after 11 months of usage and the car company they want to buy back at full price 85K,,, I told them this is not a personal use SUV, is for business use.  and they told me the max is 85K for buy back and + 20K for additional damage, total is 105k,,,, I know I need to pay the 20k as 1099 income,  but the bottom line is my 2021 tax deduction are using 100% section 179 which is 89k,,,,,,,,what can I do by the end of the year for other over 6000lbs vehicle add back to 2021 tax return?  or I have to pay back the IRS on the deduction that I got from 2021? 

[Opus 17]

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@STC3 wrote:

does anyone know, ( I used my SUV for section 179 deduction and now the car's company want to buy back my SUV due to lemon law, what should I do now for last year (2021) tax deduction?     will I need to pay back all the deduction amounts? that is over 25K payment to IRS.

I got the SUV for 89k and after 11 months of usage and the car company they want to buy back at full price 85K,,, I told them this is not a personal use SUV, is for business use.  and they told me the max is 85K for buy back and + 20K for additional damage, total is 105k,,,, I know I need to pay the 20k as 1099 income,  but the bottom line is my 2021 tax deduction are using 100% section 179 which is 89k,,,,,,,,what can I do by the end of the year for other over 6000lbs vehicle add back to 2021 tax return?  or I have to pay back the IRS on the deduction that I got from 2021? 

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This is a duplicate question that was already answered.  

If you purchased a vehicle in 2021 and placed it in service as a business vehicle under section 179, and then sell it in 2022, you will have to recapture the unused depreciation.  Turbotax will do this for you.  Yes, you will have a taxable gain.  You will list the vehicle as "sold" for the amount of the settlement (it doesn't matter why it was sold, just the date and the price).  Turbotax will do the rest.  You don't amend your 2021 return. 

The 20k is not "1099 income" or "other income."  Since this is a business vehicle, the 20K will be business profit.  You simply list the vehicle as "sold" for the $105K that you get.  If you had legal expenses, you can deduct them as a business expense.  If you paid for repairs, you can deduct them as vehicle expenses.  Whatever is left over will be taxable income to the business on your schedule C.  

For example, if you took section 179 in 2021, you deducted the entire price, so your adjusted cost basis is zero.   In 2022, you received $105K of business income when you sold the vehicle.  You would be allowed about $17K of depreciation for 1 year of business use, so you will have a taxable gain of about $88K.  If you had $20K of expenses, you can deduct them, but if your "expenses" are just lost business opportunities/lost profits, there is nothing to deduct.  You can't deduct a loss from money you never received, and if the 20K is replacement for lost business income, then it is taxed as if it was business income.

[ChrisPD]

To all the Turbo Tax Alumni,

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.

My situation: I was awarded a settlement under the state Lemon Law for $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 less the amount of the settlement :($46k original FMV - $19k FMV at time of settlement = $27k loss), so $40k settlement - $27k loss in value = $13k taxable income. There is no FMV value declared in the settlement because the vehicle was not traded or 'turned in' to a dealer. It was a cash and keep situation.

Robert G. from earlier in this blog chain indicate that it's the difference between the original FMV purchase price and the settlement amount ($46k original FMV - $40k settlement = $6K loss). 

So you can see that depending on who's advice you follow it can result in an entirely different situation, where I owe taxes on $13k or I have a loss of $6k.

Can anyone help?  I had also paid Turbo Tax for the online assistance last tax season and asked this same question and all they did was search this blog for an answer so that tells me that Turbo Tax support may not know either, especially if there are multiple versions of the 'correct way' to handle this situation.  I'm hoping that I can get a definitive answer. Thank you!

[Opus 17]

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@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?

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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.

[ChrisPD]

So if my adjusted basis in the example is $6k ($46k original purchase price - $40k settlement), and I traded the car in this year (2022) on a new car and the trade in value was $22k, then my taxable gain would be $16K, which is the trade in value of $22k less the adjusted basis of $6k.  I don't know whether or not I'm going to receive a 1099 because the attorney was very quick to tell me they don't advise on tax matters and would not tell me whether or not I'll get a 1099. Would this all be reported as other income or some  type of gain on sale of?  The vehicle was used for personal use only...I don't own a business.

[Opus 17]

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@ChrisPD wrote:

So if my adjusted basis in the example is $6k ($46k original purchase price - $40k settlement), and I traded the car in this year (2022) on a new car and the trade in value was $22k, then my taxable gain would be $16K, which is the trade in value of $22k less the adjusted basis of $6k.  I don't know whether or not I'm going to receive a 1099 because the attorney was very quick to tell me they don't advise on tax matters and would not tell me whether or not I'll get a 1099. Would this all be reported as other income or some  type of gain on sale of?  The vehicle was used for personal use only...I don't own a business.

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You basically sold the vehicle to the dealer for $22K, so if you previously had the settlement, you would report this as a long term capital gain (assuming you owned the car more than 1 year).  You can manually enter this in Turbotax under the section for sales of stocks and other investments.  Report the purchase date as-is, the purchase price as your adjusted cost basis of $6K, the selling date as the trade-in date, and the selling price as the $22K.  Long term capital gains are taxed a bit less than regular income.  

(If you think about it, another way to report it would be as you purchased the car for 46K, and sold it for 22K+40K, which will equal the same ultimate result of a long term gain of $16K.)

[ChrisPD]

Champ,

if I eventually receive a 1099 for the $40k settlement how should I record it in Turbo Tax since I’m reporting a long term net gain that includes it? Thanks 

[ChrisPD]

Opus 17,

If I receive a 1099 for the $40k settlement in 2022 and traded in the car in 2022, would I still need to report the 1099 income in my Form 1040 as well as the long term capital gain when I traded in the car?

Would the 1099 Misc income be entered, as some have suggested, as proceeds from a law suite settlement $40k, then under Misc Rev and Exp  as less common revenue as a negative amount ($40K), thus netting it to zero for income reporting purposes?  In addition would I also record  the net gain (the example was $16k) on the sale of the car as a long term asset? Thank you for your help!

[Opus 17]

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@ChrisPD wrote:

Opus 17,

If I receive a 1099 for the $40k settlement in 2022 and traded in the car in 2022, would I still need to report the 1099 income in my Form 1040 as well as the long term capital gain when I traded in the car?

Would the 1099 Misc income be entered, as some have suggested, as proceeds from a law suite settlement $40k, then under Misc Rev and Exp  as less common revenue as a negative amount ($40K), thus netting it to zero for income reporting purposes?  In addition would I also record  the net gain (the example was $16k) on the sale of the car as a long term asset? Thank you for your help!

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There are 3 ways I can think of to deal with a 1099-MISC for the settlement.

1. Do as you suggest, add the 1099 as other income, then add a minus $40K other income amount to offset it, then report the capital gain separately, and e-file.

2. Ignore the 1099 and e-file.

3. Leave the 1099 off your return and file by mail.  Attach a copy of the 1099 and a written statement explaining the situation and why the income is not taxable as other income (and that you did report it as a capital gain).

#3 is the official instruction from the IRS but it doesn't take into account the reality that paper-filed returns are backlogged and sometimes lost, and e-filing is strongly advised.  #1 is the typical advice from Turbotax experts, but you may get a letter from the IRS asking to explain the offsetting entry.  (You can't attach an explanation with your return, but save your documents for at least 3 years so you can send an explanation with proof if asked.)  #2 is least complicated to file but will definitely result in an IRS letter you will have to respond to later.  I would go with #1.  

[ChrisPD]

THANK YOU! 😀