Question: A few years ago, I individually loaned a friend a sizeable amount of money. Since there is no chance I will be repaid, can I report a tax deduction for the amount loaned?
Answer: Individuals who loan money in the non-business setting to others, be they friends, family members or others, are not entitled to income tax deductions when borrowers default and fail to repay the loans. Taxpayers are allowed to claim non-business bad debts which are wholly worthless as short-term capital losses.
The Internal Revenue Code does allow tax losses for business bad debts. Generally speaking, these are debts in the business context. Loans by a bank or financial institution to customers, for example, are business loans, the non-payment of which can be deducted as business expenses. A sale to a customer who fails to pay for merchandise purchased would also constitute a business bad debt. Deductions are allowed for losses in other business settings as well.
The deduction of short-term capital losses is generally limited. Taxpayers with short-term capital losses can offset first short-term and then long-term capital gains with the amount of their bad debt losses. Excess capital losses can offset ordinary income of up to $3,000 per year; any unused losses can be carried forward for deduction against other capital gains and ordinary income in future tax years, subject to the same limitations.
There may be a silver lining for spurned creditors who maintain a portfolio of marketable securities outside of retirement accounts. Many individuals that own stocks and other equity securities in non-retirement accounts are often reluctant to liquidate these positions and pay tax on the appreciation in these assets. For an individual with a bad debt loss or any other capital loss for that matter, the existence of that loss provides flexibility to sell an appreciated equity position and avoid or reduce the corresponding tax obligation. The same holds true with taxpayers holding other capital assets which have appreciated in value.
One significant issue is determining when a bad debt loss is allowable for tax purposes. A taxpayer can claim a non-business bad debt loss when the debt becomes wholly uncollectable. There are circumstances where the non-collectability of a debt is obvious. Such events would include a debtor filing or having filed against him or her a bankruptcy petition or an unsuccessful collection against a debtor by a creditor seeking to be repaid the debt. Where a borrower is evicted from a residence or having a mortgage foreclosed against him or her, the borrower’s creditor may also have sufficient basis to establish the inability to collect the personal debt.
In many cases there is no bright line test to determine when a debt is uncollectable. Taxpayers are required to take reasonable steps to collect bad debts. At a minimum, a creditor should undertake some investigation as to the debtor’s ability to pay. Better support for the loss would be Instituting a collection action against the debtor and then discovering the debtor has insufficient assets to pay the debt.
In any case where there is some ambiguity as to when a bad debt loss is allowable, a creditor should attempt to claim the loss sooner rather than later. If a creditor reports a bad debt loss in a calendar year and the IRS challenges the loss claiming the debt was uncollectible in an earlier tax year, the creditor may be unable to amend the tax return for the earlier tax year to claim the loss if the applicable tax Statute of Limitations has expired for the earlier tax year. On the other hand, if a creditor claims the loss too soon and the IRS maintains that the debt was not uncollectible until a later tax year, the creditor may still have the opportunity to claim the loss on an ensuing year’s income tax return.
On additional hurdle for claiming bad debt losses is establishing that the loan was in fact a loan. The IRS might take the position that a loan was a gift or never intended to be repaid. This issue most frequently arises in the familial setting. To bolster the characterization of the exchange of funds as a loan, the lender should insist the borrower execute a promissory note. The note should specify the amount borrowed, provide a definite time for repayment and carry a market rate of interest. Undocumented loans are much more likely to be challenged by the IRS as something other than a borrowing transaction.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfbbg.com.
