Tax treatment of legal costs: how to deduct litigation expenses

After a judicial proceeding concludes, the winning party usually receives an award for legal costs. This income raises doubts regarding its treatment in the income tax return, specifically whether it should be considered a taxable capital gain.

What the DGT has ruled

The Directorate General of Taxes (DGT) has established that an award for legal costs has a restorative nature. This means its purpose is to compensate the party that has won the lawsuit for the economic damages derived from the litigation.

To determine whether a capital gain exists, the taxpayer can apply the following criteria:

• The amount received for legal costs can be offset against the expenses incurred due to the lawsuit.
• The maximum limit for this deduction is the total amount received as legal costs.
• If the amount of expenses incurred is equal to or greater than the amount of the award, no capital gain will occur.

What this means for you

If you are an individual who has won a judicial process and has received the payment of legal costs, this money is not necessarily a net income that must be taxed in full. The regulations of the Personal Income Tax Law (Ley del IRPF) allow the amount received to be neutralized by the costs you had to assume to carry out your legal defense.

In practical terms, if the money awarded by the court to cover legal costs is less than what you have spent on lawyers, court agents (procuradores), and other judicial concepts, you will not have to declare a capital gain for this item.

What you should do

It is fundamental to maintain exhaustive documentation of all costs derived from the proceeding. To be able to apply this deduction and avoid undue taxation, it is necessary to have the invoices and receipts for the expenses incurred in the lawsuit. Each situation is unique, so it is recommended to assess the available documentation to determine the exact impact on your income tax return.