When Can You Deduct Nonbusiness Debts?

Find out when you can deduct a nonbusiness (personal) loan as a bad debt.

By , J.D.

If you loan money to your no-good brother-in-law and he never pays it back, can you deduct the amount from your taxes as a bad debt? Maybe.

As far as the bad debt deduction is concerned, there are two types of debts: business and nonbusiness. Business debts arise from the conduct of your business. Nonbusiness debts arise from your nonbusiness activities such as making personal investments or personal activities. Money you lend friends, relatives, and others for purposes other than business is a nonbusiness debt.

Nonbusiness bad debts can be deducted as short-term capital losses, provided you meet certain strict requirements.

Requirement #1: Legitimate Loan

First, the money you gave the borrower must have been a legitimate loan, not a gift. You make a gift when you lend someone money with the understanding the it need not be repaid. You get no deduction for gifts. The IRS says that "debt is genuine if it arises from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum of money." To prove your debt's validity, you should have a written promissory note signed by the borrower. The note should set forth the amount of the loan, the collateral, if any, the interest rate, and the repayment terms. You should charge interest, since non-interest loans look like gifts to the IRS. You must also take steps to collect the debt when it becomes overdue.

Requirement #2: You Loaned Out Cash

You must have actually loaned cash to someone who does not repay it to have a nonbusiness bad debt deduction. Thus, for example, you cannot claim a bad debt deduction for court-ordered child support not paid to you by your former spouse. Nor can you take a bad debt deduction for unpaid salaries, wages, rents, fees, interest, dividends, and similar items. If you own securities that become totally worthless, you can take a deduction for a loss, but not for a bad debt.

Requirement #3: Entire Loan Is Uncollectible

You can take a deduction for a nonbusiness debt only if the entire debt is uncollectible. You do not have to wait until the entire debt is overdue to determine whether it is worthless. Nor do you have to file a lawsuit to collect the debt, obtain a judgment against the debtor, and then try, unsuccessfully, to collect on it--a process that can take years.

All that is required is for you to show that there is no longer any chance that the loan will be repaid. Obviously, you must show that you took reasonable steps to collect the debt. But even collection efforts would not be required if the debtor files for bankruptcy, since such a filing stops all debt collection efforts by the debtor's creditors.

When to Deduct

Nonbusiness bad debts are deductible in the year they become worthless. If you do not deduct a bad debt on your original return for the year it becomes worthless, you can file a claim for a credit or refund due to the bad debt. You must file within 7 years from the date your original return for that year had to be filed.

Short-Term Capital Loss

Nonbusiness bad debts are treated as short-term capital losses. Such losses are first deducted from your short-term capital gains, if any. If your net short-term losses exceed your short-term gains, your net short-term capital losses are then deducted from your total long-term capital gains for the year. If your net short-term losses exceed the long-term gains, the excess short-term loss is deductible against up to $3,000 of your other income. Any amount remaining can be carried forward and deducted in future years.

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