Loans often exist among family members. It is not unprecedented that some of these loans don’t get paid back. When loans among family members aren’t paid back, it is possible for the lender to take a tax deduction for the bad debt.
While the IRS allows people to claim bad debt deductions for loans to family members, because of the close relationship between lender and borrower, the deductions are subject to close scrutiny. Unless the lender can prove that a bona debt exists, the loan will be treated as a gift to the borrower and no deduction will be allowed.
Proving the Amount Loaned is a Real Loan and Not a Gift
To establish that a family debt is bona fide, the intent of the parties to create a binding debt is significant as well as how similar the loan arrangement is to normal commercial arrangements.
The following characteristics help establish that a debt is bona fide:
- A written loan agreement
- A reasonable rate of interest is charged
- There is a fixed payment schedule
- Security or collateral is obtained
- The borrower is solvent when the loan is made
- The borrower makes payments on the loan
- The lender makes a demand for repayment when the borrower is delinquent
Legal action is not required to show that an effort was made to collect on the loan. If the circumstances indicate that legal action would be futile, worthlessness of the loan can be established without legal action.
Rules for Nonbusiness Bad Debts
A loan between family members will generally be considered a nonbusiness bad debt. As such, it is treated as a short term capital loss. Short term capital losses are deductible against capital gains, then against up to $3,000 of ordinary income each year. If the lender does not have capital gains (or can’t sell assets to create capital gains) it may take several years to fully deduct the bad debt.
Example: Tina lends $50,000 to her son, Timmy, so he can start a business. There is a written loan agreement, a reasonable interest rate is charged, and Timmy makes monthly payments on the loan. After a year Timmy’s business fails and he is insolvent. The loan balance is $45,000. Tina makes a demand for payment, but Timmy can’t pay her back. Legal action will probably be futile since Timmy is insolvent and near bankrupt. Tina can probably claim a $44,000 nonbusiness bad debt. If Tina has no capital gains, she can only deduct $3,000 of this bad debt per year.
Example 2: Tina has $10,000 in capital gains in the year Timmy defaults. Here, Tina can offset the $10,000 of capital gains with the bad debt and she can deduct an additional $3,000 of the bad debt against her ordinary income. The remaining balance of the bad debt deduction can be carried forward.
Example 3: Same facts as example 1, except that Tina has no current capital gains. She does; however, have stock that has appreciated $40,000. She can sell this stock, recognize a $40,000 capital gain, offset $40,000 of the capital gain with the bad debt deduction, and deduct an additional $3,000 of the bad debt against her ordinary income. The remaining $1,000 of bad deduction will be carried forward.
It is important to keep in mind that the family member who’s loan is being forgiven may have debt forgiveness income. However, the debt forgiveness income may be tax-free if the borrower is insolvent, bankrupt, or in certain other circumstances.
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Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.