If you lend someone money, there's always the possibility that you'll never get it back, no matter how much you trust the person. When you make a personal loan and it becomes clear that there's no chance of repayment, it's considered a bad debt for Internal Revenue Service purposes.
A personal loan that becomes a bad debt can be considered a capital loss for tax purposes and used to offset capital gains and some ordinary income.
Understand IRS Personal Loan Rules
If you take steps to get repaid on a personal loan, and there's no reasonable expectation that you'll ever get your money back, you can declare it as a bad debt. You don't have to sue the person to whom you loaned money for it to be a bad debt.
Once a personal loan in tax terminology becomes a bad debt, you can legally declare a short-term capital loss in that year. You must file IRS Form 8949, which deals with capital gains and losses, to declare the loan a bad debt. You must also file a statement with your tax return explaining the debt, including how much is owed, when it was due, who owes you the money, how you tried to collect and why you determined the debt was effectively worthless. If it is a family loan or you have a business relationship with the person you loaned money to, you must spell that out as well in the statement.
When you claim a short-term capital loss, you can deduct the amount of the loss from any short-term capital gains you had that year. Short-term capital gains are taxed at your normal ordinary income tax rate. If you had more short-term capital loss than gain, you can deduct the remainder from your long-term capital gains. If you still have losses left over, you can deduct up to $3,000 of that capital loss from your ordinary income. You can roll over any losses still left over to the following year, when you may repeat that procedure.
Ensure Family Loans Aren't Gifts
You are not allowed to claim that a gift was a loan and deduct it when someone does not pay you back. If you make a family loan or a loan to a friend and are serious about getting paid back, it's a good idea to treat the loan like a formal business arrangement and have the recipient sign a promissory note, agreeing to pay back by a certain time and pay interest. Otherwise, the IRS may be unwilling to believe that it was a genuine loan and not a gift.
Know 2018 Tax Rules
If you are deducting bad debt from long-term capital gains in 2018, you will cut your tax bill according to the long-term capital gains rates. Capital gains are taxed according to your taxable income, and if your income is below $38,600, or $77,200 for married couples filing jointly, they are untaxed, so there is generally no point in documenting bad debt if it would only offset capital gains and you made less than that amount. If the debt would offset some ordinary income as well, it can be worthwhile to document and deduct it.
Remember 2017 Tax Rules
For the 2017 tax year, capital gains rates are based on your ordinary income tax brackets. If you're in the 10- or 15-percent tax bracket, your long-term capital gains are untaxed, so there's no point writing off bad debt unless it is going to offset your ordinary income through the $3,000 rule.
- Internal Revenue Service: Topic Number 453 - Bad Debt Deduction
- NOLO: When Can You Deduct Nonbusiness Debts?
- Internal Revenue Service: Publication 550 (2017), Investment Income and Expenses
- AccountingWeb: Treating Non-Business Bad Debt as Short-Term Capital Loss
- The Motley Fool: Your Guide to Capital Gains Taxes in 2018
- The Motley Fool: Long-Term Capital Gains Tax Rates in 2017
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.