Can I deduct a loan to a friend or family member that goes bad?

This is a question that comes up in our practice from time to time. There are instances when a friend or family member is in need of money whether it is to go to school, start a business or help them in a time of need. We loan the money with the hope that the funds will be returned to us at a time and date when the friend or family member is in a better place financially.

Just like businesses, loans by their very nature carry an element of risk. What happens when that friend or family member never get to that “better place” or due to unforeseen circumstances, they choose not to repay the loan? These non-business bad debts can be deductible on your individual tax return in the year that it’s determined that there is no chance that the loan will be paid back (i.e. death, disability, written notice). 

While we would hope that loans to friends and family would be repaid as originally agreed, we’d like to provide some tips to substantiate your deduction if the need should arise:

• Intent: If you lend money to a friend or relative without the intent to be repaid, it’s considered a gift and not a loan. Both parties need to agree that this is a loan with the intent to repay it at some future date.
• Documentation: Loans should be documented in writing and preferably signed by both parties. The documentation should include: date of loan, amount of loan, terms of repayment and interest rate (if any).
• Follow Up: When the term of the loan is up, there needs to be some sort of attempt to collect payment from the debtor. Documentation of phone calls, e-mails or correspondence should be kept on file along with any responses from the debtor regarding their ability or intent to repay the loan.

If you have a situation where a loan to a friend or family member may not be collectible or you receive a request, please contact your KOS tax advisor for help and tips to structure this in a way that protects your interests in case of a default.