Loaned a Friend Money They Never Paid Back? It Could Serve as a Tax Break

You may not be totally out of luck.

Being asked to lend money to a friend can be tricky. On the one hand, you don't want to say no and see someone you care about struggle -- especially if you're in a solid place financially with plenty of money in savings.

On the other hand, when you lend money to a friend, things have the potential to go very wrong. At the very least, it can make for an awkward situation. And in an even less ideal scenario, you might end up not getting repaid the money you lent out.

If that's the situation you're in, you may be able to claim a loss on your taxes. But you'll need to meet specific criteria to snag a tax break.

How to claim a loss for an unpaid loan

If you gave a friend a loan that hasn't been paid back, you may be able to claim a tax deduction for what the IRS calls a nonbusiness bad debt. But to claim that tax deduction, you'll need to prove that:

• The money you gave over was an actual loan, not a gift.
• You handed over actual cash.
• The debt you're owed can't be collected on.

To satisfy the first requirement, you'll generally need copies of a loan document that was signed by you and the person you lent money to. Ideally, that document should contain details such as the amount of the loan and its repayment terms.

To satisfy the second requirement, you must have loaned money directly to a friend who isn't paying that money back. If you have a copy of a cashed check for $5,000, and you have loan documents stating you made a $5,000 loan, that should generally work.

But to be clear, you can't claim a tax deduction for a nonbusiness bad debt if your friend simply promised you money and never came through. For example, if you and your friend shared an apartment and you "loaned" them money by covering their half of the rent for one month, that unpaid sum doesn't count.

Finally, you'll need to prove that your debt can't be collected on, and that may be the toughest barrier on the road to snagging your tax break. You can try providing copies of letters or emails that show your attempts to get repaid. Or, you might satisfy this requirement if you can show that your friend has filed for bankruptcy and has no assets available to repay you with.

Claiming your tax deduction

If you're eligible to claim a tax deduction for a nonbusiness bad debt, it will be treated as a short-term capital loss, similar to the type of loss you might take if you sell a stock for less than what you paid for it within a year of buying it. Short-term capital losses can be used to offset short-term capital gains -- for example, if you sell a stock at a profit in your brokerage account within a year of acquiring it.

If you don't have short-term gains, you can use your loss to offset long-term gains. And if you don't have those, you can use a short-term loss to offset up to $3,000 of income, and then carry the rest of your loss over into a future tax year.

Be careful when lending out money

The decision to lend money to a friend can backfire on you if you aren't careful. If you're asked to provide a friend with a loan, make sure you document it in writing and come up with a reasonable repayment plan you're both on board with.

At the same time, be honest with yourself about your friend's likelihood of paying you back. If you're talking about a friend who's always worked consistently but recently fell on hard times, that's one thing. But you may want to reconsider lending money to a friend who never seems to have a steady job and constantly relies on credit cards to get by.

There's nothing wrong with being friends with someone whose financial house isn't in order. But you don't want to end up in a situation where you're sitting on a loan that's never going to be repaid. And so if you're asked for a loan by someone you can't trust to pay you back, you shouldn't hesitate to simply say no.