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A reader, Gerard, reached out to us recently wondering if there was any way to recover any of the thousands of dollars loaned to a friend. At this point, he doubts the person actually intended to repay the loan. Here’s what he told us:

We posed the question to Burton M. Koss, senior tax adviser at Cortés & Baker, an accounting firm in Hilliard, Ohio. Koss said it’s possible that the loss could be claimed on taxes, but first Gerard and his mother will have to do some investigating to conclude the debt is uncollectable. “If it is really a bad debt, it’s a capital loss,” he said.

“If the person who borrowed the money has any assets, or if they have a job and their wages could be garnished, then the debt may not be worthless,” Koss said. “You may be able to collect the money. You should consult an attorney to explore the possibility of filing a lawsuit.” If the borrower has assets or income, it may make sense to hire a lawyer to write a persuasive letter about repayment of the debt, he said.

The tax treatment depends on whether it’s a business loan. In Gerard’s case, Koss thinks it’s likely it’s a nonbusiness loan even though it was partly for business reasons. “A loan is only considered a business bad debt if the lender made the loan as part of the regular operation of the lender’s business,” he said. “If the lender is an individual who is not operating a business, then it is a nonbusiness bad debt.”

Taxwise, it would be similar to buying bonds in a company that went bankrupt. “It is essentially an investment that went bad, and the value of the investment is now zero,” Koss said. It is treated as a capital loss, which means you can deduct only $3,000 of the loss, unless you have a capital gain to offset. The remaining amount is carried forward to the following year. You can deduct up to $3,000 each year until it is used up.

The first step is to determine whether the debt is worthless. “If you are certain that you could not collect the money even if you filed a lawsuit and won, then the debt may be worthless. I recommend that you consult a professional tax adviser for assistance with the preparation of your tax return,” Koss said.

Making loans to family and friends can be a complex business. Though it can and sometimes does go well, it also has the potential to harm relationships if repayment doesn’t go the way people expected. Many experts recommend against lending money you cannot afford to give. (Or at the very least, you should be able to afford to make it a gift so that repayment is not required to make your own budget work).

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