Legal fees incurred to recover fire insurance proceeds are not deductible.

In 1991, Mr. and Mrs. Jasko's residence was destroyed by fire. The loss was covered by fire insurance. The Jaskos incurred $71,000 in legal fees during 1991, 1992 and 1993 in a dispute with the insurance company over the home's replacement cost. In 1992, they paid $25,000 of those legal fees and deducted them on their 1992 tax return as a miscellaneous deduction. The IRS disallowed the deduction under IRC section 212(1), which allows individuals to deduct all ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income. Because the Jaskos did not hold their house for the production or collection of income, the legal fees were not deductible. The Jaskos conceded this point but claimed the insurance policy should be considered separate from the ownership of the home, and therefore the legal fees incurred to regain the house's full replacement cost should be deductible.

Result: For the IRS. The Tax Court rejected the Jaskos' argument that the insurance policy should be separated from the residence. Citing the "origin of claim" doctrine, the court said the policy was meant to reimburse the Jaskos by providing the replacement cost of a home. Without the home and the fire, the insurance policy would be meaningless, so the home and the fire were the origin of the Jaskos' legal claim. The Tax Court also concluded that the destruction of the house by fire was the equivalent of disposing of a capital asset or an involuntary conversion. Therefore, the legal fees were a nondeductible capital expenditure. They could, however, be used as an offset against any gain the Jaskos may have realized from the insurance proceeds.

* Jasko, 107 TC no. 3 (1996).