SR Client Question: Can I deduct a bad debt to a family member?

borrow moneyIt happens, your relatives ask to borrow some money, and you, against your better judgment, loan them the money…..   It is not unprecedented that some (ok, most) of these loans do not get paid back. When loans among family members are not 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.

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 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.

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, it may take several years to fully deduct the bad debt.

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.  Please contact your ShindelRock tax professional if you have any further questions.