Most of us have lent money to friends, relatives, coworkers, or others sometime or other and not been repaid. This is always an unfortunate life lesson. However, you may be able to recover some of your losses by 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 arises from your trade or business. All other bad debts—for example, debts arising from loans made for personal or investment purposes--are nonbusiness bad debts. It’s harder to deduct nonbusiness bad debts than business bad debts. It’s usually pretty obvious whether a debt is for business or not.
Example: Mark, an advertising agent, lends $10,000 to his brother-in-law, Scott, to invest in his bird diaper invention. Mark will get 25% of the profits if the invention proves successful. This is an investment, not a business debt.
Example: Mark lends $10,000 to one of his best business clients to keep the client’s business running. Because the main reason for the loan was business related (to keep his client in business so he will continue as a client), the debt is a business debt.
To deduct a nonbusiness bad debt, you have to show that:
Bona Fide Debt
To be a bona fide (genuine) debt, there has to a valid and enforceable obligation for repayment arising from a true debtor-creditor relationship. Quite simply, when you made the loan, you must have intended and expected to be repaid. If you lend money to a relative or friend with the understanding that the money need not be repaid, you've made a gift not a loan. You cannot take a bad debt deduction for a gift.
If you guarantee a debt that becomes worthless, you cannot take a bad debt deduction for your payments on the debt unless you can show either (1) that you made the guarantee to protect your investment, or (2) you guaranteed the loan for a profit motive. If you make a loan guarantee as a favor to a relative or friend, and do not receive anything of value in return, your payments are considered a gift and you cannot take a deduction.
You don’t necessarily have to have a written agreement with the person to whom you loan money, but it is always better if you do. This is especially true if you loan money to a relative. The IRS will usually consider such loans to be nondeductible gifts unless you have documentation proving otherwise. A simple loan document showing who's borrowing the money and how much, and when and how it's to be repaid (including an interest amount) will usually be enough to show a bona fide debt.
To deduct a bad debt, you must have a basis in it—that is, you must have already included the amount in your income or loaned out your cash. Thus, for example, you cannot claim a bad debt deduction for unpaid alimony owed by your former spouse. If you are a cash method taxpayer (as almost all individuals are), you cannot take a bad debt deduction for unpaid salaries, wages, rents, fees, interest, or dividends. This is true even though they are owed to you. On the other hand, you can take a bad debt deduction for the amount you deposit with a contractor if the contractor goes broke and you are unable to recover your deposit. If the deposit is for work unrelated to your trade or business, it is a nonbusiness bad debt deduction.
To be deductible, the debt must be totally worthless—that is, the entire amount must be uncollectible. Unlike business bad debts, you can't take a deduction for partially worthless nonbusiness bad debts. For example, if you lend $2,000 to a friend and he pays back $500, but never pays the remainder, you don’t qualify for a nonbusiness bad debt deduction.
You're not required to wait until a debt is due or past due to determine that it's worthless. Often, it will be clear that a debt is uncollectible long before the due date—for example, where the borrower has filed for bankruptcy.
A debt becomes worthless when you know there's no chance you'll be repaid and you've taken reasonable steps to collect it. You don't necessarily have to sue the borrower to prove that a debt is uncollectible. Filing a lawsuit would be pointless, for example, if the borrower has filed for bankruptcy or it is otherwise clear he or she has no money or assets to satisfy any court judgment you could obtain.
You should document your efforts to collect the debt with emails, written demands for payment, invoices, or phone calls.
You can take the deduction only in the year in which the debt becomes totally worthless. Unlike business bad debts, nonbusiness bad debts are classified as short-term capital losses for tax purposes. As such, they are subject to the limitations on taking short-term capital losses: You can deduct such a loss against any short or long-term capital gains you have for the year from the sale of capital assets (such as real estate and stocks). First, you deduct the loss against short-term capital gains--gains earned on capital assets held less than one year. Next, you deduct any remaining loss against long-term capital gains--gains on capital assets held over one year. Any remaining amount of your loss is deductible only up to $3,000 per year against your other ordinary income. Any amount left over may be carried over to be deducted in future years.
Example: Phil incurred a $10,000 nonbusiness bad debt on a loan to his brother-in-law. He had $5,000 long-term capital gain on the sale of stock. He deducts his $10,000 loss from his $5,000 gain, leaving $5,000. He may deduct $3,000 more from his ordinary income (salary income from his job). He carries the remaining $2,000 forward to be deducted the following year or years.
You claim a nonbusiness bad debt deduction by filing IRS Form 8949, Sales and Other Dispositions of Capital Assets with your annual income tax return. In Part 1, line 1, enter the name of the debtor and the words "bad debt statement attached" in column (a). Enter your basis in the bad debt--the amount of money that has not been paid back--in column (e) and enter zero in column (d). Use a separate line for each bad debt. You must also attach a separate statement to your return that:
Don't panic. If you didn't take a deduction in the year it became worthless, you may be able to file an amended return to claim a credit or refund due to the bad debt. You must file IRS Form 1040X, Amended U.S. Individual Income Tax Return, to amend your return within seven years from the date your original return for that year had to be filed, or two years from the date you paid the tax for that year, whichever is later. This is much longer than the normal three-year period to file an amended return. So if you’ve lent money to anyone over the past seven years, and they haven’t repaid you and it’s clear they never will, you may be able to file an amended return and get a tax refund.
