In any real estate, acquisitive or restructuring transaction, legal fees and other consultant fees can become a substantial cost during the deal. IRS regulations outline several limitations on deductibility, so it is important to understand these limits and potential exceptions to capitalization to maximize the “after-tax” dollars spent on legal fees and other transaction costs.
Generally, amounts paid “to produce or facilitate the acquisition of real (tangible, immovable property such as a house) and personal property (movable or intangible property such as stocks)” have to be capitalized into the cost basis of the property. Additionally, amounts paid to “facilitate the acquisition of a trade or business, a change in the capital structure of a business entity and similar transactions” may also need to be capitalized.
These are known as facilitative costs and include amounts paid to attorneys in the process of investigating or pursuing the purchase of property. Whether costs are facilitative is based on facts and circumstances. It does not matter that a cost would or would not have been incurred but depends upon the purchase of the property in determining the requirement for capitalization. Accordingly, taxpayers will need to better understand what is included in their attorney’s invoice to determine what fees must be capitalized into the cost of property.
Investigatory Phase Costs
Pre-decisional costs may be deductible by taxpayers. This means investigatory and pursuit costs paid or incurred in the process of trying to determine whether to proceed with a transaction are deductible, unless they are inherently facilitative costs (in which case they are capitalized). The regulations provide a list of inherently facilitative costs incurred in the investigatory phase that must be capitalized into the basis of the property. Among other costs included:
- Securing an appraisal or determining the value or price of property
- Negotiating the terms or structure of the acquisition and obtaining tax advice on the acquisition
- Preparing and reviewing the documents that effectuate the acquisition of the property (for example, preparing the bid, offer, sales contract or purchase agreement)
- Examining and evaluating the title of property
- Obtaining regulatory approval of the acquisition or securing permits related to the acquisition, including application fees
- Conveying property between the parties, including sales and transfer taxes, and title registration costs
- Finder’s fees or broker’s commissions, including contingency fees
- Services provided by a qualified intermediary or other facilitator of §1031 like-kind exchange
Taxpayers should be prepared to request detail from their attorneys and other consultants in order to appropriately categorize legal and transaction fees and maximize deductibility. Taxpayers should also consider utilizing safe harbor elections where available. Some larger organizations may seek to maximize the use of in-house counsel or other employees to maximize the deductibility of legal and transaction fees. If invoicing fees to your clients, you should be familiar with these rules and the potential impact to your client.