You've probably made a loan to someone you know, "just until payday," or "after the new job pans out." There are countless situations and reasons for lending someone money. Unfortunately, you're not always repaid.
There may be some relief, though. You may be able to recover some of your losses taking a tax deduction for nonbusiness bad debts.
For tax purposes, you have a "bad debt" when you're owed money and you can't collect it. There are two kinds of bad debts: business and nonbusiness. You have a business bad debt when it's related to your trade or business.
All other bad debts are nonbusiness bad debts, like the money you lend to a friend. In certain situations, you can take a tax deduction when the debt isn't repaid.
For example, you're a self-employed interior decorator and you lend a friend some money so she can pay her rent. If you can't later collect on the loan, it's deductible only if it qualifies as a nonbusiness bad debt. That's because you're not in the money-lending business, and the loan isn't connected to your business.
Qualifying for the Deduction
Other than the requirement that the debt can't be connected to your trade or business, to deduct a nonbusiness bad debt, you have to show that:
- The debt is bona fide
- You have a basis in the debt
- The debt became totally worthless in the year you claim the deduction
Bona Fide Debt
To be a bona fide debt, there has to be a debtor-creditor relationship, and there has to be a valid and enforceable obligation for repayment.
The main idea here is to show that, when you made the loan, you intended and expected to be repaid. So, if you lend money to a friend and there's no understanding between you that it must be repaid, you've made a gift, and you can't take a deduction for a gift.
An oral agreement may do the job, but something in writing is better. A simple loan document showing who's borrowing the money and how much, and when and how it's to be repaid will usually be enough to show a bona fide debt.
Basis in the Debt
Basis means you have some real investment in the debt, that is, you've already included the amount in your income or loaned out your cash. Obviously, you can't claim a bad debt on a loan you never made, but what's included in income mean?
Most individuals (as opposed to businesses) use the cash method of accounting. This means that you don't count items as "income" until you actually receive it. So, for example, you can't take a bad debt deduction for alimony or wages you're not paid, even though it might be owed to you.
To be deductible, the debt must be totally worthless. Unlike business bad debts, you can't take a deduction for partially worthless nonbusiness bad debts.
For example, in January 2010 you loaned your brother $1,000 with the understanding that he'd repay it, with interest, in two equal payments due in June and December. He makes the June payment but not the December payment. You can't deduct the unpaid portion because the entire debt is not worthless.
You're not required to wait until a debt is due or past due to determine if it's worthless. A debt becomes worthless when you know there's no chance you'll be repaid and you've taken reasonable steps to collect the debt. You don't have to sue the borrower to prove that the debt's uncollectible, either. For example, it's usually enough to show that the borrower filed bankruptcy after you made the loan.
Taking the Deduction
You can take the deduction only in the year in which the debt becomes totally worthless. For example, if your sister didn't repay a loan in 2010 as promised and it becomes worthless in that year because she filed bankruptcy, then you must claim the deduction on your 2010 return.
You take the deduction by claiming a short-term capital loss on Schedule D of your Form 1040 tax return. Here, you'll give the name of the debtor and the amount of the bad debt. You also need to attach a separate statement to your 1040 that:
- Describes the debt, including the amount, and the date it became due
- Specifies the debtor's name and any business or family relationship between you and the debtor
- How you tried to collect the debt
- Why you determined that the debt was worthless
Did you Miss a Deduction?
Don't panic. If you didn't take a deduction in the year it became worthless, you may be able to file a claim for a credit or refund due to the bad debt. You have to file an amended return for the year the debt became worthless. You have to file the amendment within seven years from the date your original return for that year had to be filed, or 2 years from the date you paid the tax, whichever is later.
Questions for Your Attorney
- Can I take a bad debt deduction if my brother didn't repay a loan by the date promised but has agreed to pay me back when he can?
- Can I take a bad debt deduction for money I paid a contractor who never started on my home remodeling project and now can't be found?
- In 2009, I claimed a nonbusiness bad debt on a loan I made to my brother-in-law. During Christmas in 2010, he surprised me by repaying me in full. He said he won some money gambling. What should I do? Do I need to tell the IRS that I was repaid?