Contributed by: KristineS, FreeTaxUSA Agent, Tax Pro
If you loaned money to a friend, family member, or other personal acquaintance with the understanding they’d pay it back, and then they didn’t, you likely have a non-business bad debt. While this might affect the relationship in a bad way, it might also affect your tax return in a good way.
Under certain circumstances, the IRS may allow you to write off the unpaid loan on your tax return as non-business bad debt. Before you consider writing it off however, the IRS has strict criteria you’ll need to meet, including your ability to show the money was intended as a loan with repayment, not as a gift that may or may not get paid back.
A non-business loan, or non-business bad debt, must meet certain criteria in order to be considered a loss to write-off on your tax return. It's reported on Form 8949, Sales and Dispositions of Other Assets as part of Schedule D. You may claim a bad debt in the year it becomes worthless and deduct it as a short-term capital loss.
Here are some criteria the IRS uses to establish the nature of non-business bad debt:
✔ The loan must have been a bona fide loan, not a gift, with an expectation of repayment
✔ You charged interest to the borrower
✔ The borrower signed a repayment schedule or Promissory Note
✔ You made efforts to collect on the debt - phone calls, text messages, letters, emails
✔ The debt must be 100% worthless, meaning there's no chance you'll get paid back
“A debt becomes worthless when the surrounding facts and circumstances indicate there's no reasonable expectation that the debt will be repaid.” Read more on IRS Tax Topic 453, Bad debt reduction.
If you think you meet criteria to write-off a non-business bad debt loan, follow these steps.
In FreeTaxUSA software you’ll enter the bad debt on the Stock or Investment Sale Information screen. Follow this menu path: Income < Common Income > Stocks or Investments Sold (1099-B) > Add an Investment Sale.
- Click "Other" panel
- Choose who owned this bad debt
- Choose "One at a time"
- Choose “I didn’t get a tax form”
- Enter the name of the debtor as the "Investment Description."
- Enter the "Date Acquired" as the date the bad loan started.
- Enter the date the debt became worthless as the "Date Sold."
- Enter zero as the "Sale Proceeds."
- Enter the amount of the debt as the "Cost or Other Basis."
If you e-file your return, be sure to keep all documentation and notes on the loss should the IRS request additional information. If you mail your tax return, include a brief letter of explanation using the above criteria as a guide.
If you ever collect any money in the future from a loan that was previously written off, you’ll report it as income following the same menu path, except the Cost or Other Basis is $0 and the Sale Proceeds is the amount you collected.
