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Bad Loans To Friends And Family May Be Tax Deductible

Are you a soft touch? Have you lent money to relatives or friends and never been repaid?

If so, you may at least be able to get a tax deduction for the bad loan.

As far as the bad debt deduction is concerned, there are two types of debts: business and nonbusiness.

Business debts arise from the conduct of your business.

Nonbusiness debts arise from your nonbusiness activities, such as making personal investments or personal activities. Money you lend friends, relatives and others for purposes other than use for a business in which you actively participate is a nonbusiness debt.

So if you loan money to your no-good brother-in-law and he never pays it back, can you deduct the amount from your taxes as a bad debt? Maybe.

Nonbusiness bad debts can be deducted as short-term capital losses, but some strict requirements must be satisfied.

Requirement No. 1: Legitimate loan…

First, the money you gave the borrower must have been a legitimate loan, not a gift. You make a gift when you lend someone money with the understanding that it need not be repaid. You get no deduction for gifts.

The IRS says that “debt is genuine if it arises from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum of money.”

To prove your debt’s validity, you should have a written promissory note signed by the borrower. The note should set forth the amount of the loan; the collateral, if any; the interest rate; and the repayment terms. You should charge interest, since noninterest loans look like gifts to the IRS. You must also take steps to collect the debt when it becomes overdue.

Requirement No. 2: You loaned out cash…

You must have actually loaned cash to someone who does not repay it to have a nonbusiness bad debt deduct. Thus, for example, you cannot claim a bad debt deduction for court-ordered child support not paid to you by your former spouse.

Nor can you take a bad debt deduction for unpaid salaries, wages, rents, fees, interest, dividends and similar items. If you own securities that become totally worthless, you can take a deduction for a loss, but not for a bad debt.

Requirement No. 3: Entire loan is uncollectable…

You can take a deduction for a nonbusiness debt only if the entire debt is uncollectable. You do not have to wait until the entire debt is overdue to determine whether it is worthless. Nor do you have to file a lawsuit to collect the debt, obtain a judgment against the debtor, and then try, unsuccessfully, to collect on it — a process that can take years.

All that is required is for you to show that there is no longer any chance that the loan will be repaid. Obviously, you must show that you took reasonable steps to collect the debt. But even such collection efforts would not be required if the debtor files for bankruptcy, since such a filing stops all debt collection efforts by the debtor’s creditors.

When to deduct…

Nonbusiness bad debts are deductible the year they become worthless. If you do not deduct a bad debt on your original return for the year it becomes worthless, you can file a claim for a credit or refund due to the bad debt. You must file within seven years from the date your original return for that year had to be filed.

Short-term capital loss…

Nonbusiness bad debts are treated as short-term capital losses. Such losses are first deducted from your short-term capital gains, if any. If your net short-term loss exceed your short-term gains, your net short-term capital losses are then deducted from your total long-term capital gains for the year. If your net short-term loss exceeds the long-term gain, the excess short-term loss is deductible against up to $3,000 of your other income. Any amount remaining can be carried forward and deducted in future years.