When friends or family borrow from you and then default, the IRS allows a bad debt tax deduction — if you documented the loan and file the right forms.
“Oftentimes, people just lend money without taking any steps to document the loan,” says CPA Brian Greenberg, of Greenberg and Associates in Marlton, New Jersey. “The creditor remembers the loan, but the borrower has short-term memory loss. If you have nothing documented, you’re out of luck.”
There are two types of bad debt: business and nonbusiness. Personal loans to friends or family are nonbusiness loans. Though you know the borrower well, taking the proper steps to document such loans makes the difference in whether you’ll be able to take a tax deduction.
How to document the loan
The gold standard for documentation is similar to what a bank requires — a signed, notarized document outlining the terms and interest, Greenberg says. (See the sample promissory note on this site).
The interest rate should be fair: Check the federal rates, published monthly by the Internal Revenue Service, says CPA and certified financial planner Brian Preston of McDonough, Georgia, host of “The Money Guy Podcast.” These rates are the minimum interest a lender should charge on a personal loan to avoid tax complications.
Include a payment plan, a balloon date when the entire amount is due, or both, Preston says. “Have the whole loan due with interest by this date.”
Although thorough documentation is ideal, some proof is better than a distant memory of a handshake and handing over cash, a check or your credit card. For example, “Have a note drawn up saying ‘I’m lending you $500. You are to pay me $50/month for 10 months,'” Greenberg says. “It’s not perfect, but at least there is a written document that states money was lent, which should help jog even the most memory challenged borrowers.”
If you the write a check for the borrower, note on the memo line that it’s a loan, says CPA and certified financial planner Rob Carmines of Carmines, Robbins & Company in Newport News, Virginia. Save all emails related to the loan in case you need them for documentation, Carmines says. If you send a personal letter, make a copy, Preston says.
Don’t try to disguise a gift as an unpaid loan for tax purposes. “Was there ever any intention of being repaid?” Carmines says. “If you give money to your mom for a new car to drive and she’s living below the poverty line on Medicare, it’s pretty clear that’s not a loan. Those questions are only important if the IRS picks your return to look at. The odds are small, but they’re not zero.”
As the IRS notes in its Topic 453, “Bad Debt Deduction” instructions, “For a bad debt, you must show that there was an intention at the time of the transaction to make a loan and not a gift. If you lend money to a relative or friend with the understanding that it may not be repaid, it is considered a gift and not a loan.”
Proper documentation also will make it clear to the borrower that though they may be a friend or family, you mean business. “It doesn’t mean you can’t make the loan out of love, but you can be organized and protect yourself as much as possible,” Preston says. “It might have the side benefit of having the borrower take you more seriously. He may think, ‘Let me pay this person back first because he’s counting on it.'”
For cash-basis taxpayers — and that’s most Americans who don’t have a business — bad debt deductions are available only for money you took in as income and then lent out. It doesn’t apply to money you expected to receive for services rendered, so if you fixed Uncle Joe’s car or replaced your buddy’s water heater, you can’t deduct the money they promised but failed to pay.
Determine if the debt is uncollectable
Once the borrower has missed a few payments on his loan, you may be able to get his attention by sending him a 1099-C form for cancellation of debt, Carmines says. This form often is used when a bank sells a foreclosed house or when credit card debt is resolved. It’s not required to send the form in order to take a tax deduction, but at the very least it shows the IRS that you’re following the rules.
If that doesn’t prompt your friend to pay up, file for the deduction the year the loan becomes uncollectable, Carmines says. That’s why having a payment plan showing a firm due date for the loan helps. “If you haven’t been paid by then, that can be the triggering event to say this debt isn’t collectible,” Preston says. If your borrower filed for bankruptcy, that’s further proof the loan is uncollectable, Carmines says.
How to file the bad debt deduction
When you’re ready to file, here’s how the deduction works. If you have capital gains, you can use the bad loan to offset those capital gains, Preston says. So if you had $10,000 in capital gains and a $10,000 bad loan, you could deduct the entire uncollected loan.
To file the bad debt deduction, get IRS form 8949, and follow the instructions. You’ll enter the debtor’s name and “bad debt statement attached” in column (a). The “basis” — which usually translates to the amount you loaned — in column (e). If you got nothing back from the borrower, the proceeds are nothing, so you put a zero in column (d).
For more information on nonbusiness bad debts, see an in-depth discussion of investment income in IRS Publication 550.
If you have no capital gains for the year of the default, you can still deduct a maximum of $3,000 per year in bad loans against ordinary income, Preston says. So, for that $10,000 loan, you could deduct $3,000 one year against ordinary income, $3,000 the next year, $3,000 the third year and $1,000 the fourth year (assuming no capital gains for four years), he says.
It may seem like a hassle (and potentially an extra cost for a tax accountant’s time), but Greenberg and Preston both say it’s worth filing. In the 25 percent tax bracket for an uncollectable $10,000 loan, you’d save $2,500 in taxes if you offset ordinary income (or $1,500 if you are offsetting long-term capital gains taxed at 15 percent), Preston says. Even for a $1,000 loan that went bad, you’d save $250 (or $150, respectively). “It certainly shouldn’t cost $150-$250 to add that additional form,” he says.
Now let’s say your formerly deadbeat friend comes through and pays the debt after you’ve already taken the deduction. All you need to do is file with the IRS showing that amount as income and pay the applicable taxes, Preston says.
Lending beats co-signing
Tempted to co-sign a loan instead of making one yourself? Don’t do it. Making the loan yourself is better than co-signing, especially when it comes to a future tax deduction for a deadbeat borrower, Preston says.
“If you don’t have the money to loan the individual, you have no business guaranteeing the loan either,” he says. If the borrower doesn’t make the required payments, you’re on the hook to pay back the money. But the IRS won’t allow a deduction for paying back a loan you co-signed, he says.
“Co-signing a loan is a disaster,” Preston says. “Be smart about it. Don’t guarantee the loans: Make the loans.”
See related: Lending to friends and family: Your 4-step guide, How to say ‘no’ to loved one’s money requests, 1099-C surprise: IRS tax follows canceled debt