Someone wise once said that you should never lend money to anyone if you expect to be paid back. The Internal Revenue Service (IRS) is sympathetic toward those who lend money—expecting repayment—but subsequently get burned. You can write off bad debts when this happens, even if you're not a business, but it's important to know the rules that apply.
Is it a debt or a gift?
The debt must have been a bona fide loan—you gave the money with every expectation of being repaid. If you charged interest, and the borrower signed a promissory note, this provides a good indication that you expected to get your money back.
Otherwise, the IRS might consider the exchange to be a gift, particularly if the borrower is a friend or a family member. And gifts aren't tax deductible.
The debt must be worthless
The unpaid debt must be 100% worthless before you can deduct it. There must be no chance that the borrower can or will ever pay you back the amount of the loan. It is important to make a documented effort to collect your money with:
- Phone calls
If the borrower files for bankruptcy, this is clear evidence you can’t be repaid.
How to report the loss
The actual task of reporting a bad debt is relatively simple. The steps are:
- Complete Form 8949 Sales and Other Dispositions of Capital Assets
- Enter the amount of the debt on line 1 in part 1, and write the name of the debtor in column (a)
- Enter your basis in column (e)—the amount of money that has not been paid back
- In column (d), write 0—the amount the borrower did not repay
The IRS also requires that you attach a bad-debt statement to your tax return, explaining the details of the loan you made. You must deduct a bad debt in the year it becomes worthless. If you realize you could have reported and taken a deduction for an unpaid debt years ago but didn't, you generally have only three years to amend your return in order to claim it on your tax return.
How to deduct bad-debt loss
Generally, you can't take a deduction for a bad debt from your regular income, at least not right away. It's a short-term capital loss, so you must first deduct it from any short-term capital gains you have before deducting it from long-term capital gains.
Finally, you can deduct up to $3,000 of any remaining balance from other income. If a balance still remains, you can carry it over to subsequent years.
For example, if you lent someone $10,000 that will not be paid back, the deduction might work out something like this:
- $10,000 original debt—$2,000 from short-term gains = $8,000
- $8,000 balance—$2,000 from long-term gains = $6,000
- $6,000 balance—$3,000 from other income = $3,000
- $3,000 balance carried over to the next year = $10,000 total deduction you can claim.
It may take a few years, but eventually you'll be able to claim the entire loss incurred on your tax returns.