You are allowed a bad-debt deduction if you have made a loan that becomes worthless, provided a bona-fide loan exists, such as for a down payment on a home or to start a business. The IRS often challenges write-offs when loans to family members sour, though not always successfully.
Deposits. It’s not widely known but the IRS won’t quibble about a bad-debt deduction if you make a deposit or advance payment and the seller fails to deliver the promised product – for example, you put a deposit on a new house and the builder goes bankrupt before the house is finished.
Debtor’s return to prison rendered debt worthless. In 1973, Stewart Oatman loaned $800 to his brother, then in the military and imprisoned in the stockade at Fort Bragg. They had an understanding that the loan would be repaid when the brother “got on his feet.”
Subsequently, he was in and out of the slammer, until 1978, when his circumstances seemed to change. He then married, had a job, and was on work release from prison.
Unfortunately, Stewart’s brother violated the conditions of his work release and was tossed back into the brig.
Stewart wrote the loan off as worthless, reasoning that the return of his brother to prison in 1978 meant there was no longer a reasonable prospect of repayment. The IRS contended that Stewart didn’t expect repayment or, if he did, the debt became worthless in a year other than 1978.
The US Tax Court accepted Stewart’s “credible testimony” that the $800 was a loan made “with the genuine understanding that the amount would be repaid,” an expectation that vanished in 1978 when the brother went back to prison.