Most of us have loaned money to a friend or relative at some time. Things don't go according to plan, and the payments stop coming -- if they ever got started. Eventually, you realize you're never going to see your money again.
If the amount you loaned was a substantial sum, you may be able to take tax deductions in the year the debt becomes uncollectible. Here's how.
1. Determine if it's a business or nonbusiness bad debt
Business debts and nonbusiness debts are handled differently on your tax return.
You could have a business bad debt when you had to pay for workers and material suppliers when a builder or contractor failed to pay them and placed a lien on your property, for example.
You cannot take a deduction for a business bad debt for income you never reported. If you're on the cash basis for tax purposes, and your customer doesn't pay you, you can't take a deduction because you never claimed the income.
You report bad debts associated with your business income and expenses. If you have a sole proprietorship, this means you report bad debts on Schedule C.
You have nonbusiness bad debt if you loaned money to someone and the borrower went bankrupt or for some other reason became unable to pay you back.
You may also have a bad debt if you guaranteed a debt that became worthless, and you had to pay up. But in this case you must be able to show that you guaranteed the debt to protect your investment or that you had a profit motive. If you guaranteed a debt as a friend, with no consideration in return, and the debt goes bad, it is considered a gift and not a loan.
2. Determine when the debt became uncollectible
You can only take a bad debt in the year it becomes completely worthless. That's when you're sure you have no chance of being paid, whether or not the debt is due yet.
The debt becomes uncollectible when you try unsuccessfully to collect on it. It's also uncollectible if the borrower files for bankruptcy and the debt is discharged. You don't have to take the borrower to court to prove a debt is worthless.
It's important to take the deduction in the year it becomes uncollectible. If the debt became worthless in a prior year but you didn't take a deduction, you can't just take the deduction for this year instead. You'll need to file an amended return, Form 1040X, for the year in which the debt became worthless. Unfortunately, you're not allowed to pick and choose the year in which the deduction would give you the greatest tax benefit.
Don't delay filing your amended return. You have seven years from the due date for your original tax return to file an amended return for a deduction for uncollectible bad debts, or two years from the date you paid the tax for that year, whichever is later.
3. Document your bad debt
To take a tax deduction for a bad debt, you must show that you had a legal debt and that you cannot collect on it. Gather this information:
- The note or agreement showing you had a legal, enforceable debt. You don't need lots of legal paperwork, but you do need to have had an understanding with the borrower that you were to be repaid. Otherwise, you made a nondeductible gift. An oral agreement is permissible, but a written one is better.
- The name of the debtor and his or her business or family relationship with you.
- Records showing your basis in the debt, usually the amount of money you loaned. You can't take a bad debt deduction for money you never received, such as uncollected alimony.
- Documentation showing you tried to collect on the debt. Letters, emails, notes from phone calls, and so on will work.
- Your notes about why you decided the debt is worthless; for example, if the borrower went bankrupt. You can only deduct debts when they are totally worthless, not because borrowers are late making payments or may not repay the entire loan.
4. Enter the bad debt on your tax return
Enter bad debts on Form 8949, Sales and Other Dispositions of Capital Assets. You'll take a short-term capital loss for your nonbusiness bad debt. The bad debt first reduces any capital gains on your return, and then reduces up to $3,000 of other income, such as wages. If you cannot take the full deduction in the year of the loss, you can carry it forward to later years.
If you've already filed a return for the year in which the debt became worthless, file Form 1040X, Amended U.S. Individual Income Tax Return, with Form 8949.
What happens if a bad debt comes back to life?
Say you've given up on getting paid back on a loan, and taken a tax deduction for a nonbusiness bad debt. If you later collect on the debt, part or all of the amount you received may be counted as taxable income to you.
But you'll only have to pay income tax on the amount of bad debt that actually reduced your tax. For various reasons, this may be less than the amount you deducted when you filed your return with the bad debt deduction.