Tax Deductions for Default

Tax Deductions: Are Unpaid Loans Tax Deductible?

John loaned his friend Jack $1,000. Jack did not repay the debt and left town. John wants to know if he can claim any tax deduction, and, if so, what is the character of the deduction? However, to answer John's question, one must first find out more information about the nature of the loan. This is critical because there are two broad types of loans and debts: business loans and personal loans. Furthermore, under the correct circumstances, it is possible for people to take tax deductions for certain types of business loans and personal loans. Knowing whether John made Jack a loan from his personal money or from his business money is the crucial first step in determining which, if any, Internal Revenue Service (IRS) regulations or tax laws will permit John to deduct the unpaid debt.

If John is a business owner and made the loan to Jack through his business, he may be able to qualify the loan as a business loan. Generally, business debts arise through the conduct of one's business. Therefore, if Jack is, in addition to John's friend, a business associate of his, this provision may apply. Some examples of business bad debts include: loans to clients or suppliers, credit sales to customer, or business loan guarantees (IRS, 2013). However, a client who has failed to pay for a service does not count as a bad debt, because for money to be considered a bad debt, it must have been loaned and lent. "A business deducts its bad debts from gross income when figuring its taxable income. Business bad debts may be deducted in part or in full. You can claim a business bad debt using either the specific charge-off method or the nonaccrual-experience method" (IRS, 2013).

The more likely scenario is that Jack is simply a friend of John's and that the loan was a personal one that had nothing to do with John's business. Even if the loan was made so that Jack could engage in his business, the test is whether it was related to John's business. Therefore, it would probably qualify as a nonbusiness debt. As the name implies, nonbusiness debts arise from nonbusiness or personal activities. Generally, money lent to friends or others for any purposes other than a business in which the lender actively participates will be considered a nonbusiness debt (Fishman, 2013).

Once it has been determined that the loan is a non-business loan, there are several requirements that one must meet in order to deduct it from one's taxes. It must be a legitimate loan. It must have been in cash. Finally, the loan must be worthless. Unless all three of these conditions apply, John will not be permitted to deduct the amount of his loan to Jack.

It appears that John meets the requirement of a legitimate loan. A loan differs from a gift in the expectation that it will be repaid; if money is lent with an understanding that repayment is optional, then it is a gift and does not qualify. It appears that John lent Jack the money with the belief that Jack would repay the loan. Therefore, at least at first glance, it appears that it is a legitimate loan. However, John may run into a hurdle when trying to prove the legitimacy of the loan. Generally, to prove that a debt is valid, there should be a written promissory note signed by the borrower. "The note should set forth the amount of the loan; the collateral, if any; the interest rate; and the repayment terms" (Fishman, 2013). There is not enough information to determine whether Jack signed a promissory note. Furthermore, there is not enough information to know if the agreement included interest. Whether or not John was charging Jack interest can be important, "since noninterest loans look like gifts to the IRS" (Fishman, 2013). In addition, if there was collateral to secure the debt, then John needs to have taken steps to secure that collateral when Jack failed to repay the debt. In fact, John needs to be able to demonstrate that he took steps to collect on the loan (Bailey, 2014). That Jack left town is insufficient; John does not have to demonstrate extensive efforts to locate him, but if Jack has a forwarding address, John should make some attempt to collect at that address.

The second requirement appears to be fulfilled. The hypothetical says that John loaned Jack $1,000, with the presumption that it was cash. However, it is possible that the loan was not a cash loan. For example, John could have lent Jack his credit card and allowed him to make a $1,000 purchase, which would not have been a cash loan. It is important that the money has already been included in income (Bailey, 2014). This could be especially problematic in that same credit card scenario where the amount is paid over an extensive time period, between years. Generally, one cannot take a bad debt deduction for money that is due, interest, dividends or other similar items (Fishman, 2013).

The third requirement also appears to be fulfilled. Personal debts differ from business debts in that they are only deductible if the entire amount of the debt is a bad debt. "You can take a deduction for a nonbusiness debt only if the entire debt is uncollectable. You do not have to wait until the entire debt is overdue to determine whether it is worthless. Nor do you have to file a lawsuit to collect the debt, obtain a judgment against the debtor, and then try, unsuccessfully, to collect on it -- a process that can take years" (Fishman, 2013). If John is unable to locate Jack, that should be sufficient to show that there is no chance that Jack will repay the loan.