Like Kind Exchanges and Lawsuit Settlements
Volume 12, Number 50,
Issue 597
For the past several years, Congress has been concerned that taxpayers were inappropriately combining the §1031 like-kind exchange rules with the §121 home-sale exclusion rules.
For example, assume you own a highly-appreciated commercial building worth $500,000. You swap that building in a tax-free, like-kind exchange for a $500,000 beach resort home that you rent to an outsider for a reasonable period of time. Later, you move into the beach home and establish it as your principal residence for 2 years. Under prior law, you could then sell the beach home and exclude up to $250,000 of gain ($500,000 on a joint return) under the home-sale exclusion rules. To curb this perceived abuse, the Jobs Act provides a new rule. Effective for home sales after October 22, 2004, if you sell your residence and it was acquired in a tax-free, like-kind exchange within the five year period ending on the date of the sale, any gain on the sale is taxable.
The new rule doesn't change the requirement that you must "use" the residence as your principal residence for 2 years out of the 5-year period ending on the date of the sale, it merely adds a new 5-year waiting period where the residence was acquired in a like-kind exchangee.
When a taxpayer receives a settlement in a personal injury case, the payment of attorneys fees is always an issue. After years of controversy, Congress has resolved the issue of how to deduct attorney fees relating to taxable damage awards. Unless you are recovering for a "physical" personal injury, most lawsuit recoveries are fully taxable.
However, courts in some circuits (5th, 6th, 9th, and 11th Circuits) believe that an individual is taxed only on the damage award net of any attorney's fees paid with regard to the lawsuit. In other circuits (2nd, 4th, 7th, 10th, and Federal Circuits), courts have held that an individual is taxed on 100% of the damage award, and is entitled to a "miscellaneous itemized deduction" for the resulting attorney's fees. Unfortunately, a miscellaneous itemized deduction cannot be deducted for "regular" tax purposes, except to the extent all itemized deductions exceed 2% of adjusted gross income. Furthermore, these deductions are not allowed at all for alternative minimum tax (AMT) purposes.
Consequently, individuals receiving payments in circuits that treat attorney's fees as miscellaneous itemized deductions pay significantly more taxes than plaintiffs recovering in circuits that only tax the award net of attorney's fees. Effective for fees and costs paid after October 22, 2004, with regard to any judgment or settlement taking place after October 22, 2004, the Jobs Act allows an "above-the-line" deduction for claims of unlawful discrimination, certain claims against the Federal Government, and certain claims under the Medicare Secondary Payer Statute.
Because this deduction is now "above-the-line," the attorney's fees and court costs will no longer be subject to any percentage reduction applied to itemized deductions, and can be claimed fully for AMT purposes. The United States Supreme Court is poised to settle this issue for judgments, settlements, and related fees before October 23, 2004. If you have settled a lawsuit in the past and treated the attorney's fee as a "miscellaneous itemized deduction," you should consider filing a protective claim for refund before the statue of limitation runs for that tax year. This could enable you to recover your taxes if the Supreme Court rules that taxable damage awards are included in income net of attorney fees. We will gladly help you prepare a protective claim for refund.
David B. Robinson, CPA
This issue is dedicated to the fine folks at the Dahesh Museum of Art in New York who bent over backwards to make me feel at home. www.daheshmuseum.org
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