Loan to a longtime friend has become a bad debt

Q: In high school I was part of a group of four very close friends. We supported each other during some tough times. Three of us went on to be fairly successful without any serious money worries. The fourth has struggled to get footing financially. A little over a year ago she called and asked if she could borrow money to start a new business. This was not her first business effort and the others had failed. My husband advised me not to loan her any money. In the end I gave in and loaned her $20,000. She signed a note to pay me 6% interest plus principal, with all payments due in 24 months. It’s probably obvious where this is heading. The business is shuttered and I have no payments. Technically the loan is not even due yet. This year has been pretty good for us and we could use a write-off in 2019. Do I need to wait until 2020 when the 24 months expires to claim a tax loss or can I do it now? As my husband often reminds me, there is no way that my friend will be able to pay me. She has no business and no savings. I also found out that one of my other high school friends had loaned her money years ago and never received any payments. I’m not sure if that would help show a history to support my case.

The tax law does allow a deduction for a bad debt. For a lender not in the trade or business of lending, the loss is treated as a short-term capital loss. This means it can only be used to offset capital gains for the year, or may otherwise be claimed at the rate of $3,000 per year. Any unused loss carries forward to future years.

Whether a debt has gone bad is a factual issue. This means that it depends on the overall circumstances. To claim a full $20,000 loss (unpaid interest cannot be claimed as a loss) you need to be able to show that there is no hope of recovery of any of the loan principal.

Although you are not in the business of lending money, to build a case for a 2019 loss you should be able to show that you have taken the same steps that a commercial lender would take to enforce payment.

I will assume that you have no collateral for this loan (or that if you did it expired with the death of the business). Some tax advisers might tell you that you need to show some very specific steps to enforce the loan, perhaps even including hiring an attorney to collect the debt.

You do need to show that you took some action to collect the debt, but it need not be as formal as outlined in the preceding paragraph. For one thing, the loan, by its terms, is actually not in default at this time.

Although no payments are due yet, the tax issue remains: Has this loan gone bad? Can it be objectively be concluded that no payments will be made based on an examination of all surrounding facts and circumstances?

It sounds to me that you have made a reasonable case that no payments will be received and that this can be inferred from the facts known in December of 2019. This would support claiming a $20,000 short-term capital loss in 2019.

You do need to document the “story” surrounding this loan and its likelihood of repayment. You need to be able to answer the questions I posed above. You also need to understand that an IRS agent might disagree with your recovery assessment.

Let’s say that you claim the loss in 2019 and the friend later shocks you, and perhaps more your husband, by repaying the debt. I would suggest that if your 2019 assessment was reasonable the appropriate treatment would be a capital gain for the payments later made.

Recording any future payments as a capital gain, and not amending the 2019 tax return, is based on something called the “relation back” doctrine. This was developed by the Supreme Court in a case called Arrowsmith.