Can I Write Off a Loan to a Family Member on My Taxes?
Learn how tax rules apply to family loans, including documentation requirements, interest rates, and potential deductions for unpaid debts.
Lending money to a family member can be generous, but if they fail to repay, there may be tax implications. Many wonder whether they can write off the unpaid loan on their taxes. The IRS has strict rules for distinguishing between personal loans and gifts, as well as specific requirements for deducting bad debts.
Understanding these rules is essential before assuming any tax benefits. Proper documentation, interest rates, and classification of the transaction all determine whether a deduction is possible.
Differentiating Gifts and Loans
The IRS classifies a financial transaction as a loan or a gift based on intent and structure. If money is given without an expectation of repayment, it is considered a gift and may be subject to gift tax rules. A loan implies an obligation to repay, which must be supported by clear terms. If the IRS finds insufficient evidence of repayment expectations, it may reclassify the transaction, leading to tax consequences.
One key factor is whether the lender takes steps to enforce repayment. If no effort is made to collect missed payments, the IRS may argue the transaction was never a loan. This is especially relevant when the amount exceeds the annual gift tax exclusion, which is $18,000 per recipient in 2024.
The borrower’s financial ability to repay also matters. If they have no income or assets, the IRS may view the transaction as a gift. Courts have ruled that a loan must have a reasonable expectation of repayment, not just a verbal agreement.
Documenting the Loan
Proper documentation ensures the IRS recognizes a loan as legitimate. A written agreement should outline repayment terms, including due dates, payment amounts, and consequences for non-payment. A signed promissory note specifying the principal amount, repayment schedule, and any collateral serves as formal evidence of the debt.
A record of payments further supports the loan’s legitimacy. Bank statements, canceled checks, or electronic transfers showing repayments reinforce the borrower’s obligation. If payments are inconsistent or nonexistent, the IRS may argue the loan was never intended to be repaid, preventing a tax deduction if the borrower defaults.
Legal enforceability matters. If payments stop, taking reasonable steps to collect—such as sending reminders or pursuing legal action—strengthens the case that the loan was a genuine financial arrangement. Courts have ruled that failing to attempt collection suggests the transaction was never a loan.
Stating an Appropriate Interest Rate
Setting an interest rate that complies with IRS guidelines is necessary to avoid tax consequences. The IRS establishes minimum interest rates, known as the Applicable Federal Rates (AFRs), which vary based on the loan’s term. If a loan carries an interest rate below the AFR, the IRS may impute interest, treating the lender as having received taxable income based on the difference between the AFR and the stated rate.
Beyond compliance, interest rates should reflect the borrower’s risk level and market conditions. A rate set too high may create financial strain, while one set too low can trigger tax implications. If the loan is below-market, the IRS may treat the forgone interest as a taxable gift, potentially reducing the lender’s annual gift tax exclusion. In 2024, this exclusion is $18,000 per recipient, meaning any imputed interest exceeding this amount could require filing a gift tax return.
Claiming a Bad Debt Deduction
If a family loan goes unpaid, it may qualify as a nonbusiness bad debt under IRS rules, allowing the lender to claim a deduction. To be eligible, the lender must prove the debt is entirely worthless, meaning there is no reasonable expectation of repayment. Partial deductions are not allowed for nonbusiness bad debts. Evidence such as bankruptcy filings, failed collection efforts, or written communication acknowledging default can support this claim.
A nonbusiness bad debt is treated as a short-term capital loss, regardless of how long the loan was outstanding. This means the deduction is subject to capital loss limitations, allowing taxpayers to offset capital gains in full but restricting net capital loss deductions to $3,000 per year ($1,500 if married filing separately). Any excess loss must be carried forward to future tax years. Proper classification is important, as misreporting the loss as an ordinary deduction could trigger an IRS audit or penalty.
Tax Considerations for Forgiven Debt
If a lender forgives a family loan, the IRS may treat the forgiven amount as taxable income for the borrower or a gift from the lender. The tax treatment depends on whether the lender canceled the debt as an act of generosity or due to the borrower’s financial hardship.
When a loan is forgiven without expectation of repayment, the IRS generally considers it a gift. If the forgiven amount exceeds the annual gift tax exclusion of $18,000 per recipient in 2024, the lender may need to file a gift tax return (Form 709). While most individuals will not owe gift tax due to the lifetime exemption of $13.61 million in 2024, reporting requirements still apply. If the lender has already used a significant portion of their exemption, additional taxes could be owed.
If the borrower was legally obligated to repay and the lender cancels the debt outside of a gift arrangement, the IRS may classify the forgiven amount as cancellation of debt (COD) income. This means the borrower must report the forgiven amount as taxable income unless they qualify for an exclusion, such as insolvency or bankruptcy. If the borrower is insolvent—meaning their total liabilities exceed their assets at the time of forgiveness—they may be able to exclude some or all of the forgiven debt from taxable income by filing Form 982. If not, the forgiven amount is generally subject to ordinary income tax, potentially increasing their overall tax liability.