SR Client Question: Can I deduct a bad debt to a family member? | ShindelRock (2024)

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SR Client Question: Can I deduct a bad debt to a family member? | ShindelRock? ›

When loans among family members are not paid back, it is possible for the lender to take a tax deduction for the bad debt. While the IRS allows people to claim bad debt deductions for loans to family members, because of the close relationship between lender and borrower, the deductions are subject to close scrutiny.

If you lend money to a relative or friend with the understanding the relative or friend may not repay it, you must consider it as a gift and not as a loan, and you may not deduct it as a bad debt.

The RR provides the following requisites for bad debts to be allowed as a deduction from gross income: (1) there must be an existing indebtedness due to the taxpayer which must be valid and legally demandable; (2) the same must be connected with the taxpayer's trade, business or practice of profession; (3) the same ...

A deduction is allowed in for the debt related to business and profession if the same has become irrecoverable in the previous financial year. If the loans lent by banking or finance companies are not able to recover the debts in full or part thereof, a deduction may be allowed.

However, should the lender want to deduct a bad loan on her or his taxes, the IRS requires proof of an attempt to collect the delinquent funds. Conversely, if the lender wants to forgive the loan, the unpaid amount will be treated as a gift for tax purposes.

The $100,000 Loophole.

To qualify for this loophole, all outstanding loans between you and the borrower must aggregate to $100,000 or less. Under this loophole, if the borrower's net investment income for the year is no more than $1,000, your taxable imputed interest income is zero.

Nothing in the tax law prevents you from making loans to family members (or unrelated people for that matter). However, unless you charge what the IRS considers an “adequate” interest rate, the so-called below-market loan rules come into play.

Writing off a bad debt simply means that you are acknowledging that a loss has occurred. This is in contrast with bad debt expenses, which is a way of anticipating future losses. Accounting for bad debts is important during your bookkeeping sessions.

Technically, "bad debt" is classified as an expense. It is reported along with other selling, general, and administrative costs. In either case, bad debt represents a reduction in net income, so in many ways, bad debt has characteristics of both an expense and a loss account.

A: A bad debt is deductible only if: The debt due the taxpayer is valid and legally due the taxpayer. The taxpayer should be able to prove that he has a right to enforce the collection of such debt.

How do you calculate bad debt deduction? ›

To calculate bad debt expenses, divide your historical average for total bad credit by your historical average for total credit sales. This formula gives you the percentage of bad debt, which you can also think of as the percentage of sales estimated to be uncollectable.

Thus, a bad debt is a specifically-identified account receivable that will not be paid and so should be written off at once, while a doubtful debt is one that may become a bad debt in the future and for which it may be necessary to create an allowance for doubtful accounts.

If the IRS considers this transaction a qualifying loan, then it will typically have few (if any) tax implications. It doesn't count as income for the borrower, because they will pay this money back, nor does the loan count as a gift for the lender for the same reasons.

A gift letter is a formal document proving that money you have received is a gift, not a loan, and that the donor has no expectations for you to pay the money back. A gift can be broadly defined to include a sale, exchange, or other transfer of property from one person (the donor) to another (the recipient).

Next time you decide to lend money to a friend or family member, make sure you cover all your bases so you can claim a tax write-off if the borrower can't pay you back. Getting a signed loan agreement, charging interest, and sending payment reminders is a good start.

Most personal loans cannot be transferred to someone else. There are rare exceptions to this rule, such as mortgages and car loans, but even then, it is easier to qualify for a new mortgage or car loan to pay off the existing loan. If considering a personal loan, make sure you can repay the loan in full.

The two sides must sign a promissory note that spells out the interest rate, terms and conditions, length of repayment period, and ability to transfer the loan to another party.