These being the times they are, you may be tapped for a loan by a relative or friend who is unable to come up with the down payment for a home or wants to start a business. But what if the loan goes sour, as so often happens?
The tax rules on deductions for bad debts can be more bad news for you. So, before staking someone, it’s a good idea to know how the IRS looks on worthless loans.
The IRS allows a deduction for a worthless loan if there’s no likelihood of recovery in the future. But it prohibits any deduction for an outright gift. That’s why the agency looks closely at bad-debt deductions where the lender and borrower are related and why it may insist on proof that the “loan” wasn’t really a gift.
Advance planning. Nevertheless, there are steps you can take before making a loan that will help in case a revenue agent questions your write-off. The key is to set up the transaction with the same care you would a business loan.
To begin with, you should ask the borrower to sign a note or agreement. Moreover, make sure the note spells out the amount borrowed and the dates and amounts of repayments. Charge a realistic rate of interest – say, the rate your money would earn in a savings account if it weren’t out on loan. Arrange for a witness to sign the note if the law in your state requires it.
If keeping the deal as businesslike as you can sounds like a rough way to deal with a friend or relative, remember that it’s the only way if you want to deduct a bad debt later. IRS examiners routinely throw out deductions for handshake deals.
Basis in bad debt required. The IRS cautions that a bad debt is deductible only if you’ve a basis in it – that is, you must have already included the amount in your income or loaned out your cash.