Are Legal Fees Tax Deductible in California?

Determining if legal fees are tax deductible is a complex matter, as the rules depend heavily on the specific purpose of the legal services. The answer is not a simple yes or no, but rather a nuanced analysis of whether the expense was for business, personal, or investment-related reasons. This is amplified by the differences between federal and California state tax laws. For California residents, understanding both sets of regulations is necessary to determine the deductibility of these costs.

Federal Tax Rules for Legal Fees

At the federal level, the guiding principle for deducting legal fees is whether they qualify as an “ordinary and necessary” expense of carrying on a trade or business. This means the expense must be common and accepted in your line of work and helpful for your business. If legal fees meet this standard, they are generally fully deductible. For example, costs to defend against a business-related lawsuit or to get tax advice for your business are considered deductible business expenses.

A significant change occurred with the passage of the Tax Cuts and Jobs Act (TCJA) of 2017. This law suspended miscellaneous itemized deductions for individuals for tax years 2018 through 2025. This suspension is temporary and set to expire at the end of 2025. Before the TCJA, individuals could deduct certain personal legal fees if they, combined with other miscellaneous deductions, exceeded 2% of their adjusted gross income (AGI). Unless Congress acts to extend the current law, these rules are scheduled to return for the 2026 tax year.

Despite the broad suspension, a few specific types of personal legal fees remain deductible on federal returns. Legal fees paid in connection with certain unlawful discrimination lawsuits, such as those involving employment or civil rights, are deductible. These are not itemized deductions but are claimed as an “above-the-line” deduction, which directly reduces a taxpayer’s gross income. Similarly, legal fees associated with specific whistleblower claims that result in an award from the IRS or other federal agencies can also be deducted above the line.

California State Tax Rules for Legal Fees

California’s approach to deducting legal fees presents a notable divergence from federal law, primarily because the state did not conform to the TCJA’s suspension of miscellaneous itemized deductions. This non-conformity means that many personal legal fee deductions that disappeared at the federal level are still available on a California state tax return.

For California state tax purposes, individuals can continue to deduct legal fees paid for the production or collection of taxable income. This can include fees for investment counseling or legal advice related to managing income-producing property. Additionally, fees for tax advice or tax return preparation remain deductible on the California return. These deductions are classified as miscellaneous itemized deductions.

The ability to claim these deductions on a California return is subject to a specific limitation. The total of your miscellaneous itemized deductions, including qualifying legal fees, must exceed 2% of your California Adjusted Gross Income (AGI). You can only deduct the amount that is over this 2% floor. For example, if your California AGI is $100,000, the first $2,000 of your miscellaneous itemized deductions provides no tax benefit.

Classifying Your Legal Fees by Purpose

Business-Related Fees

Legal expenses that are directly related to operating your business are generally deductible on both federal and California tax returns. These are considered ordinary and necessary costs of commerce. Examples include fees for drafting business contracts, legal assistance with employee disputes, resolving tax issues related to the business, or defending the business in a lawsuit.

Fees Related to Income Production

This category highlights a major difference between federal and California rules. Legal fees paid to produce or collect taxable income, that are not related to a trade or business, are no longer deductible on federal returns due to the TCJA. However, California law still permits this deduction. A common example is paying an attorney for advice on investments that generate taxable interest or dividends.

Fees Added to Cost Basis

Some legal fees are neither immediately deductible nor entirely lost. Instead, they are capitalized, meaning they are added to the cost basis of an asset. This increases the asset’s value for tax purposes, which can reduce the taxable gain when the asset is eventually sold. A clear example is incurring legal fees during the acquisition of a rental property. These costs, such as for reviewing purchase agreements or resolving title issues, are added to the property’s basis rather than being deducted in the year they were paid.

Non-Deductible Personal Fees

Many legal expenses are considered purely personal in nature and are not deductible on either federal or California tax returns. These include fees related to personal matters that do not involve a business or an income-producing activity. Common examples of non-deductible legal fees include those paid for:

• A divorce or separation
• Child custody disputes
• Will preparation
• Defending against criminal charges like a DUI

Legal costs associated with the purchase of a personal residence are also not deductible but can be added to the home’s cost basis.

How to Claim the Deduction on Your Tax Returns

For Federal Returns

On a federal return, the placement of the deduction depends on the nature of the legal fee. If the fees are for a trade or business, they are reported on Schedule C (Form 1040). You would list the total amount on line 17, titled “Legal and professional services.” For legal fees related to rental real estate activities, the deduction is claimed on Schedule E (Form 1040), Supplemental Income and Loss. For the specific exceptions that survived the TCJA, such as legal fees for unlawful discrimination cases, the deduction is claimed on Schedule 1 (Form 1040) as an adjustment to income.

For California Returns

Claiming deductible personal legal fees in California requires itemizing deductions. These deductions are reported on Schedule CA (540), California Adjustments. You will report the difference between federal and state law for miscellaneous itemized deductions. Specifically, you would enter qualifying expenses, such as fees for investment advice or tax preparation, on the appropriate lines of Part II of the Schedule CA.