When to Recognize That Bad Debt

So you got conned into loaning your buddy’s business some dough, and despite your efforts to collect, you’re getting nowhere.  What do you do on your tax return, and when do you do it?

Generally speaking, noncorporate taxpayers are permitted to write off, as a short-term capital loss, a loan of this nature in the year in which the loan becomes totally worthless.

Sounds good on the surface, but what if you don’t have any capital gain income in the tax year in which that 100 grand you loaned to your buddy’s business becomes uncollectible?  The result is a $3,000 deduction and a $97,000 short-term capital loss carryover!  And depending on what your activities are in future years, you may or may not derive the full benefit of the loss before you kick the bucket.

So, you say, why not initially treat the loss as an ordinary (as opposed to a capital) loss in the year of worthlessness?

And the answer is that you are simply not permitted to do so, according to the Revenooers’ Code, unless you are in the “trade or business of lending money,” which most ordinary folk who are just deploying their savings in an effort to get a return on their investment are not!  A taxpayer who truly is in the business of lending money, however, not only may derive an ordinary loss initially, but may not even have to wait until the loan has gone totally bad!

So how does a bloke decide whether he’s in such a “trade or business?”

Basically, the first requirement is that the taxpayer must show a frequent and continuous pattern of lending activities – not just an occasional loan to a friend.  These are some of the factors which have been considered in analyzing whether a taxpayer’s money lending activities truly rose to the level of a “trade or business of lending:”

  • The number of loans made by the taxpayer over a number of years;
  • The maintenance of an office for purposes of engaging solely in the lending business;
  • The maintenance of books detailing the taxpayer’s lending activity;
  • Whether the taxpayer held himself out to the public to be in the lending business;
  • Whether the taxpayer advertised his lending services;
  • Whether the taxpayer had a reputation in the community for making loans;
  • The amount of income the taxpayer derived from his lending activities;
  • Whether the taxpayer indicated on this tax returns (often on a Schedule C) that he was in the lending business;
  • Whether the loan activities were kept separate and apart from the taxpayer’s other activities;
  • The amount of time and effort expended in the lending activity;
  • The relationship between the taxpayer and his debtors; and
  • Whether the primary purpose for the loans was to make a profit from interest and loan-related fees.

It’s a pretty tough standard for most folks to meet.

CONSULT YOUR TAX ADVISOR – This article contains general information about various tax matters.  You should consult your CPA regarding the implications to your own particular situation.

Jeff Quinn, the author of this article, is a shareholder in Ashley Quinn, CPAs and Consultants, Ltd., with offices in Incline Village and Reno.  He may be reached at 831-7288, welcomes comments at jquinn@ashleyquinncpas.com, and invites readers to consider his other commentary at http://blog.nolo.com/taxes.

Leave comment