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.
The IRS requires a detailed explanation for a bad-debt deduction. Your return must be accompanied by a statement that includes the following information:
l. The nature of the debt.
2. The name of the debtor and any business or family relationship to you.
3. The date the debt became due.
4. What efforts you made to collect the debt.
5. The reason you determined the debt to be worthless.
The IRS wants good evidence that the loan is really worthless and will remain so in the future. While you have to take reasonable steps to collect it, the IRS doesn’t require you to hound a debtor into court, provided you can show that a judgment, if obtained, would be uncollectible. To be on the safe side, at least send a letter asking for repayment. As a general rule, the debtor's bankruptcy is a good indication that the debt is at least partially worthless.
An example: You loan money to your uncle for the latest of his "can't miss" deals, an emu ranch, but don’t try to collect it; several years later, he becomes bankrupt. The IRS will refuse to allow a bad debt deduction. You could’ve collected the money at an earlier date while your uncle was financially solvent, yet made no effort to do so. This, reasons the IRS, "is strong evidence that you did not intend a creditor-debtor relationship to exist between you and your uncle."
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 225 and counting).
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...