The IRS tends to be very skeptical when someone claims a tax deduction for a loss from a bad debt. The reason for this is that losses from loan transactions that ended up purported usually are from some other type of deal that went awry. For instance, a bad debt could have come from contributing money to a business that went bankrupt, or the taxpayer could have loaned a family member money without having a written contract. This is why claiming a bad debt loss deductible that will get past IRS scrutiny can be tricky, as you must first be able to prove that the loan was from a bad loan transaction and not simply a bad financial move.
IRS Regulations on Bad Debts
The IRS states that you are able to deduct a worthless loan if there is absolutely no chance of recovering it in the future. It is not possible to take out a deduction if the loan was a gift or if the person never had any intention of repaying you, which is why the IRS will look very carefully at your bad-debt deduction in order to ensure that it is legitimate. They may ask for proof that the “loan” wasn’t simply a gift or that there was intention of repayment.
Steps To Take With Your Worthless Loan
There are several steps that you can take before creating a loan that will aid you in the case that IRS agent inquirers into your tax write off. The key to ensuring your write off is successful is to ensure that the transaction is set up in the same manner that you would a business loan. Creating it in an official way will ensure that the IRS can easily check the legitimacy of your write-off. If making sure that the deal remains as business-like as possible sounds like a tough way to deal with a relative or friend then keep in mind that it’s the only way to ensure that you can deduct it from your taxes if it becomes a bad debt.
Ensure The Borrower Signs an Agreement or Note
To start off with you should make the borrower sign an agreement or note. On top of this, make sure that the note clearly states the amount that is borrowed as well as the dates and amount and frequency of repayments. Make sure that you charge a reasonable interest rate, for instance the rate that your money would have earned in a savings account if you didn’t lend it out. It is also a good idea to have the note signed by a witness whether or not your residing state requires it.
Be aware that the IRS will want solid proof that the loan is in fact worthless and will remain so forever. This means that you have taken steps in order to collect it, and not just let it go bad. You don’t have to hound the debtor or take them to court, however you do have to show that if a judgment were obtained it would be deemed noncollectable.
Non-Business Bad Debt vs. Business Bad Debt
Another factor to keep in mind is that the law is more lenient towards bad debts that are business related than for those that aren’t, like those given to a friend or relative. Business bad debts can be deducted straight from income, whereas a non-business bad debt is classified under the rules that limit deductions for short-term capital loss. Due to this, for the year that the personal loan was deemed noncollectable, you fist will utilize the loss in order to offset a capital gain, and then must use as much as $3,000 of the remaining loss in order to offset the ordinary income from your salary.
Losses from a Business Bad Debt
Losses that come from a bad debt that arises during the course of your business will be treated as an ordinary loss and not a capital loss. In most cases, ordinary losses are completely deductible without limitation. On top of this, partial worthlessness deduction can be claimed for any business debts that end up partially bad under the IRS Code Section 166.
Although it’s not widely known, the IRS will not argue about a worthless loan deduction if you make an advance or deposit payment and the seller does not deliver the product or service that was promised to you. For instance, if you put down a deposit for a new home and then the builder becomes bankrupt before he could complete the home then you are guaranteed a deduction for the money that was put down. However, you will only be able to do so in the year that the advance or deposit became worthless.