In Your Debt

Julian Block

THESE BEING THE TIMES they are, I frequently field queries from clients who are asked for loans by relatives or friends. These would-be borrowers plead their inability to come up with the down payments for homes or who want to launch “can’t fail” business ventures. Suppose, as so often happens, the loans go sour and the borrowers’ last messages mention their entry into witness protection programs.

I remind wannabe lenders who intend to stake friends or relatives to familiarize themselves beforehand with long-standing tax rules. The rules make it difficult to take deductions for bad debts. While the IRS allows deductions for worthless loans if there’s no likelihood of recovery in the future, it prohibits write-offs for outright gifts.

Lenders should expect the agency to look closely at their deductions for bad debts when they’re related by blood or marriage, or have other ties, to the borrowers. The burden is on the lenders to prove that what they characterize as “loans” weren’t really gifts.

There are steps lenders can take before making loans that will help in case the IRS questions their write-offs. The key to success: Set up the transactions with the same care as any loan made for business reasons.

Lenders should ask borrowers to sign notes or agreements that, among other things, do the following: specify how much they’re borrowing; explain when and in what amounts they’re supposed to make repayments; and require them to pay realistic interest charges––say, the rates lenders would receive from savings accounts if their funds weren’t loaned. Lenders also should arrange for witnesses to sign the notes if that’s a legal requirement in their state.

Some clients voice their concerns that imposing interest charges and other requirements are a rough way to deal with their friends or relatives. I remind them that it’s the only way if they want to deduct bad debts later. IRS examiners routinely throw out deductions for handshake deals.

When can lenders deduct unpaid loans? Only in the year that they become worthless. The IRS doesn’t require lenders to wait until the loans are past due to determine whether or not they’re worthless; loans becomes worthless when there’s no longer any chance that they’ll be repaid.

The IRS will want good evidence that the loans are actually worthless and will remain so in the future. While the IRS expects lenders to take reasonable steps to collect loans, it doesn’t require them to hound debtors into courts, provided they can show that judgments, if obtained, would be uncollectible. Still, lenders should at least send letters asking for repayment. Generally, if debtors declare bankruptcy, that’s a good indication that the debts are at least partially worthless.

Julian Block wrote and practiced law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator). He died in 2023. Check out the articles that Julian wrote for HumbleDollar.

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