Proving a bad debt tax deduction

Barry Dolowich for the Monterey County Herald writes:  Q About five years ago, I lent my brother $25,000 to help him out after he lost his job. We have since stopped talking and he refuses to acknowledge the loan or pay me back. I am sure he will never repay the loan. Can I get a tax benefit for this bad debt?

A Since this was a personal loan and not related to your business, it is considered to be a nonbusiness loan for tax purposes. A nonbusiness bad debt is deducted as a short-term capital loss on Schedule D of your Form 1040. This is a limited deduction. You can deduct the loss from any capital gains, if any, plus up to an additional $3,000 ($1,500 if you file married filing separately) against other income. Any unused capital loss can be carried forward to next year.

There are four rules to prove a bad debt deduction:

1. You must have a valid debt. Your right to repayment must be fixed and not dependent upon some event.

2. A debtor-creditor relationship must exist at the time the debt arose. You have a loss if there was a promise to repay at the time the debt was created and you had the right to enforce it. If the advance was a gift and you did not expect to be repaid, you may not take a deduction.

3. The funds providing the loan were previously reported as income or part of your capital. If you are on a cash basis, you may not deduct unpaid salary, rent or fees.

4. You must show that the debt became worthless in the year of the deduction. To prove the debt became worthless this year, you must show the following:

• The debt had some value at the end of the previous year, and that there was a reasonable hope and expectation of recovering something on the debt.

• That an identifiable event occurred this year, such as a bankruptcy proceeding, that caused you to conclude the debt was worthless.

• That there is no reasonable hope that the debt may have some value in a later year. You are not required to prove that there is no possibility of ever receiving some payment on your debt.

Planning note: It is strongly recommended that you document any loans you make with proper loan documents providing all the pertinent terms of the loan (due date, interest rate, payment terms, etc.). Obviously, it is more difficult to prove a bona fide loan (as opposed to a gift) without the proper documentation.