How To Claim Bad Debt Losses On Your Taxes

Let’s say that, a few years ago, I individually made a sizable loan to a friend. Since there is no chance I will be repaid, can I report a tax deduction for the amount I lent out? For answers, I went to Bruce Bell, an attorney at the Chicago office of Schoenberg Finkel Beederman Bell Glazer.

Larry Light: What do I need to do to write off this bad loan?

Bruce Bell: Individuals who lend money in the non-business setting, be they friends, family members or others, are not entitled to income tax deductions when borrowers default and fail to repay the loans. But 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. Non-payment 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.

Light: So that leaves reporting a capital loss for individual creditors, like me. How does that work?

Bell: 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 loss provides flexibility to sell an appreciated equity position and avoid or reduce the tax obligation. The same holds true with taxpayers holding other capital assets which have appreciated in value.

Light: What does the IRS want to see to prove that I have a bad debt on my hands?

Bell: The key is to show that the debt is not collectable. One piece of evidence is a debtor filing—a bankruptcy petition is one example. Where a borrower is evicted from a residence or the home is in foreclosure may be another.

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, you should undertake some investigation of the debtor’s ability to pay. Hire a collection agency. Perhaps the agency can document the debtor has insufficient assets to pay the debt.

Light: What’s the timing on this?

Bell: Where there is some ambiguity as to when a bad debt loss is allowable, you should attempt to claim the loss sooner rather than later. Certainly within the statute of limitations which usually falls within the five to 10 year range depending on state law. If the bad debt loss is claimed too long of a time period after the loan becomes worthless, you are out of luck.

On the other hand, if you claim the loss too soon and the IRS maintains that you didn’t give the debtor enough time to pay, you also run a risk of the IRS disallowing the loss. In this case, you likely have flexibility to report the loss in a later tax year.

Light: How do I prove this money was indeed a loan? My ex-friend could just say it was a gift. Or say it was a loan never intended to be repaid.

Bell: This happens a lot among families. You should insist the borrower give you 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.