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Be Tax Savvy! Bad Debts or Gifts?

By Tanya Roth, Esq. on February 17, 2010 2:00 PM

Consider this scenario: You lent $10,000 to your cousin Arty but when time comes to pay back that loan, Arty says "No! It was a gift!"

Your conflict with a deadbeat cousin aside, what does the Internal Revenue Service have to say about your non-business bad debt?

For starters, let's look at how the IRS treats non-business bad debts. Bad personal debts are treated as short term capital losses. This means that you can deduct them from your income tax calculation, but only up to a maximum of $3,000 above your capital gains for the year. 

What is a non-business bad debt and when would it apply to the average taxpayer?  In Publication 550, the IRS describes a non-business bad debt as a bad debt (i.e. an uncollectible debt) that has no relation to the lender's business. In order for the debt to be deductible, it must be "totally worthless" and must be a genuine debt. 

Both of those criteria come back to the question as to whether the amount was a gift or a loan. So, how do you establish that? And if it was a loan, how do you show it is uncollectible.

  1. Keep loan notes: The IRS wants to see that the amount was not a gift. A loan note can serve as good proof that the amount was meant to be repaid. It can also serve to show how genuine the loan is. 
  2. Keep checks cashed by the debtor: This helps you establish your "basis" in the loan, essentially, the amount owed to you in the loan. It will also be important to show the payments that were made by the debtor.
  3. Keep all documentation showing collection attempts: This can serve to show that the loan is "worthless". If you can't collect on the loan, it can't possibly have any worth, can it?
  4. Look for documentation on the value of collateral: If there is no value in the collateral, then it might strengthen your argument that the loan has no value and is not collectible.   
  5. Look for bankruptcy determinations of the debtor: Aah, bankruptcy. The ultimate evidence of insolvency. 
  6. Look for financial information of the debtor: If readily available, you might be able to show that the debtor does not have the funds to pay you back.

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