It's a frustrating situation but not an uncommon one: You lent money to a friend or family member and you've got the sinking feeling they'll never pay it back. If you're reasonably certain you'll never collect the funds, you can claim the unpaid debt as a loss on your tax return. Unpaid personal loans are considered non-business bad debts and generate a short-term capital loss.
Determine the Nature of the Debt
Not all debts qualify for a tax loss. If you lent a friend or family member money and it wasn't clear that you wanted it repaid, the Internal Revenue Service considers it a gift. If you have a loan document that details payment terms and dates, you can consider it a loan or a debt for tax purposes. How you cancel a debt for tax purposes depends on the nature of the debt. If you're a sole proprietor or own a business and the loan was related to your business activities, the loan is considered a business debt. Otherwise, the IRS considers it to be a non-business debt.
Before including unpaid debts in your tax return, ensure that the transaction qualifies as a bad debt in the eyes of the IRS. Attempt to collect the unpaid debt from the lendee and document your efforts. The IRS allows taxpayers to deduct bad debts only if they make a reasonable attempt to collect the balance. Taxpayers can deduct non-business bad debts only if they are entirely worthless, so hold off on deducting the debt until you're reasonably sure the debtor won't pay any part of the balance owed.
Complete IRS Form 8949
Information about non-business bad debts is recorded on IRS Form 8949, Sales and Other Dispositions of Capital Assets. In column (a) -- the description of the property -- write the name of the debtor and the phrase "bad debt statement attached." In column (d) -- proceeds from the property -- write zero. In column (e) -- the cost or other basis of the property -- write the amount the debtor currently owes you. Attach a statement that details the terms of the loan with your tax return. The unpaid amount will flow through as a short-term capital loss to your main Form 1040 tax return.
Update in Later Years
If the debtor pays you back after you claim the unpaid debt on your tax return, you must report the recovery of the bad debt to the IRS. Taxpayers can report previously deducted non-business bad debt as miscellaneous income on Form 1040.
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