The tax code authorizes more advantageous treatment for business-related bad debts than for nonbusiness bad debts, such as personal loans to relatives or friends. Unlike business bad debts, which are deducted directly from income, nonbusiness bad debts come under the rules that limit deductions for short-term capital losses.
Consequently, for the year the personal loans become uncollectible, you first use those losses and any other capital losses to offset any capital gains. Note, too, that there’s no offset of capital losses allowed against income from Roth conversions (money moved out of traditional IRAs and into Roth accounts) or required minimum distributions from retirement plans, notwithstanding that appreciation of securities was what caused the accounts to swell.
A restriction kicks in when overall capital losses exceed capital gains. Offset those net losses against as much as $3,000 of salaries and other kinds of ordinary income, including that created by Roth conversions and required distributions from traditional IRAs and other tax-deferred plans. Then carry forward unused losses over $3,000 into the following year and beyond, should that prove necessary.
To illustrate, assume that for 2017 you will wind up with no capital gains but suffer short-term capital losses of $8,000, including uncollectible nonbusiness bad debts.
First, subtract $3,000 of your capital loss from ordinary income, leaving you with $5,000 to carry forward into 2018, when the remaining loss (unless offset against capital gains) may be used to again reduce ordinary income by $3,000. Your unused loss is now down to $2,000. Carry it forward to 2019, when (unless offset against capital gains) it’s finally used up as a subtraction from ordinary income.
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About Julian Block
Attorney and author Julian Block is frequently quoted in the New York Times, Wall Street Journal, and the Washington Post. He has been cited as “a leading tax professional” (New York Times), an “accomplished writer on taxes” (Wall Street Journal), and “an authority on tax planning” (Financial Planning magazine). More information about his books can be found at julianblocktaxexpert.com.