IRS Keeps a Close Eye on Deductions for Worthless Loans, Part 1by
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.
For example, you can’t claim a bad-debt deduction for court-ordered child support not paid to you by your former spouse. Because you never had to count the child support as reportable income, you aren’t able to deduct its nonpayment.
The IRS sets strict rules for “cash-basis taxpayers.” That’s the IRS’s designation of individuals (including most of us) who generally don’t have to report income items until the year they actually receive them and don’t get to deduct their expenses until the year that they pay them. You generally can’t take a bad-debt deduction for unpaid salaries, wages, rents, fees, interest, dividends, and similar items.
When to deduct. You can take a deduction for the loan only in the year that it becomes worthless. You needn’t, however, wait until the loan is past due to determine whether or not it’s worthless; a loan becomes worthless when there’s no longer any chance of being paid what you’re owed.
Be mindful that the IRS will want good evidence that the loan is actually worthless and will remain so in the future. That means you must take reasonable steps to collect it. On the other hand, the IRS doesn’t require you to hound a debtor into court, provided you can show that a judgment, if obtained, would be uncollectible; but you should at least send a letter asking for repayment. Generally, the debtor’s bankruptcy is a good indication that the debt is at least partially worthless.
Part 2 of this article will look at bad-debt deductions and deposits, as well as how to deduct nonbusiness bad debts.
Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 180 and counting).
Stay competitive with your fellow accountants who turn to the articles when, say, they correspond with clients or they want to show clients how to nimbly sidestep pitfalls while capitalizing on opportunities to diminish, delay, or deep-six payments of sizable amounts that would otherwise swell IRS coffers.
Also be mindful of the articles when you strive to build name recognition, a goal attainable only by choosing and implementing strategies that set you apart from ferocious competition. Use the articles to prepare talks to audiences, such as business owners, investors, and retirees.