If you lend money to your Uncle Joe and he never pays it back, can you get a tax deduction? It depends.
First of all, the loan must be a true loan, not a gift. The IRS is very suspicious of loans between family members and friends. You need to carefully document such transactions. You must have the relative to whom you lend the money sign a promissory note, pay you a reasonable rate of interest, and establish a repayment schedule. Keep records showing that your relative really paid you interest. To see what promissory notes Nolo offers, go here.
Make sure you charge interest on the loan. If you make an interest-free loan, you may become subject to the IRS "below market interest rules." These rules may require you to calculate imaginary interest payments from the borrower and pay taxes on them, even though they've never been paid to you. How much interest should you charge? At least as much as the "Applicable Federal Rates" established by the IRS. You can find these rates on the IRS website (www.irs.gov).
If the loan is for business, the entire amount can be deductible in a single year, with no limit. On the other hand, a bad personal loan must be treated as a short-term capital loss. This means you first use it to offset any capital gains on investments (if any), and can then deduct up $3,000 per year to offset your ordinary income from earnings.
A business loan is a loan for a business-related purpose such as helping your relative start a new business or keep an existing business running. A personal loan is made for non-business reasons--for example, to help your relative pay for therapy to break his cocaine habit.
Finally, the unpaid loan must be worthless to be deductible. The rules differ for business and personal loans. A business bad debt is deductible whether the debt is totally worthless or partly worthless. A nonbusiness bad debt is deductible only if the debt is totally worthless.
A debt becomes worthless when there is no longer any chance that the amount owed will be paid back to you. You don’t have to wait until a debt is due to determine that it is worthless, and you don’t have to go to court to try to collect it. You just have to be able to show that you have taken reasonable steps to try to collect the debt or that collection efforts would be futile. For example:
Keep all documentation that shows a debt is worthless, such as copies of collection letters or emails you’ve sent the debtor-relative, logs of calls you’ve made to collect the debt, and bankruptcy notices.