If you make a loan to a friend or family member and they never pay you back, you may be able to claim a tax deduction for it. You only can write off a bad debt if you can prove that you expected to be paid and you made reasonable attempts to collect the debt. Bad debts are deductible as short-term capital losses, which offset short-term capital gains.
What's a Bad Debt?
In order to claim an amount as a non-business bad debt, you must have loaned out the money or already claimed it in your income. For example, if you loaned your cousin $1,000 and he refused to pay you back, that's a bad debt. If you agreed to fix your aunt's roof for $2,000 and she never repaid you, you can only claim the amount as a bad debt if you already reported it as taxable income. You can't claim a bad debt for money that you hoped to receive but never reported, like wages or rental income.
Video of the Day
Consider also: Form 1040: What You Need to Know
Proving a Bad Debt
To claim a bad debt, you should be able to prove that the amount you loaned out was a genuine loan and not a gift. This means you need evidence that you expected to be paid back. For example, if both parties signed a loan agreement and you charged interest on the loan balance, that would be powerful evidence. You also must make an earnest attempt to collect the debt before you write it off.
You can claim the bad debt only if you believe it to be entirely uncollectible. In addition, you should write it off in the year it becomes worthless.
Consider also: What Are Interest Expenses?
Bad Debt on Tax Return
Personal bad debts are deductible as short-term capital losses on IRS Form 8949. Enter the name of the person you made the loan to and the phrase "bad debt statement attached" in column 1 of Part 1, line 1. If you never received any payments on the loan, write "0" for proceeds. Your cost or other basis should be the face value of the loan.
Include a statement with your tax return that describes the debt, who the debtor was, your relationship with your debtor, how you attempted to collect the debt and why you believe that it is worthless.
Recovering Bad Debts
If the debtor does pay you back in future years, even if that is a long time in the future, you may record the proceeds as taxable income. You only need to include the amount you recovered as income if you financially benefited from initial bad debt write-off.
For example, if you claimed the bad debt deduction but it didn't reduce your taxable income because of your income level, you don't need to report the recovery. If you do recover some of the bad debt, consult with a tax professional about how much of the recovery you need to report.