Rev. Rul. 87-32: Deducting Non-Business Bad Debts

When a personal loan to a friend or family member goes unpaid, the Internal Revenue Service (IRS) allows for a tax deduction under specific circumstances. The IRS has established strict requirements for deducting a non-business bad debt to ensure claims are for legitimate loans that have become uncollectible.

Understanding these rules is necessary for anyone considering this type of deduction. Taxpayers must provide clear evidence to substantiate both the legitimacy of the original loan and that it has become completely worthless. Without this proof, a deduction cannot be claimed.

Establishing a Bona Fide Debt

The primary requirement in claiming a non-business bad debt deduction is proving that a bona fide debt existed from the outset. The IRS must be convinced that the transaction was a genuine loan, not a gift disguised to secure a tax benefit. When money is exchanged between family members or friends, the presumption is often that it was a gift, and the taxpayer must overcome this by showing a clear intent to create a debtor-creditor relationship.

To substantiate the claim of a bona fide debt, formal documentation is very helpful. The strongest evidence is a written loan agreement or a promissory note signed by both parties. Beyond a written instrument, other factors can help establish the debt’s legitimacy, including:

• A loan document that outlines the total amount, a specified interest rate, and a clear repayment schedule.
• The existence of any collateral pledged to secure the loan.
• Evidence of the borrower’s financial solvency when the loan was made.
• An interest rate that aligns with prevailing market rates at the time of the loan.

Ultimately, the taxpayer must assemble facts and circumstances that collectively point to a real and enforceable obligation for the debtor to repay the money. The more formal elements that were put in place when the loan was initiated, the stronger the taxpayer’s position will be.

Determining When a Debt Becomes Worthless

Once a bona fide debt is established, the next requirement is to pinpoint the year the debt became completely worthless. For non-business bad debts, a deduction is only permitted in the year of total worthlessness. A taxpayer cannot claim a deduction for a debt that is only partially uncollectible; the hope of recovering any portion of the loan must be gone.

The determination of worthlessness is based on an assessment of all surrounding facts that indicate there is no longer any reasonable expectation of repayment. A simple failure of the debtor to pay on the due date is insufficient. The taxpayer must demonstrate that they have taken reasonable steps to collect what was owed.

Several specific events can serve as definitive proof that a debt has become worthless, such as:

• The debtor’s declaration of bankruptcy, as the legal proceedings often formally discharge the debt.
• Proof of the debtor’s insolvency, where their liabilities far exceed the value of their assets.
• A legal judgment against the debtor that is determined to be uncollectible.
• The debtor’s death leaving behind an estate that is insufficient to cover the debt.
• The debtor’s disappearance, if the taxpayer can show a genuine but unsuccessful effort to locate them.

Tax Reporting of Non-Business Bad Debts

After establishing a bona fide debt and its complete worthlessness in a specific tax year, the final step is to report the loss correctly. The tax code treats a non-business bad debt as a short-term capital loss, regardless of how long the debt was outstanding. This classification dictates the specific forms and procedures that must be used.

The process begins with Form 8949, Sales and Other Dispositions of Capital Assets, where the debt is reported in Part I for short-term transactions. In column (a), the taxpayer should list the debtor’s name and include a phrase like “bad debt statement attached.” Column (d) should show zero proceeds, and column (e) should report the taxpayer’s basis in the debt, which is the amount of cash loaned.

The total short-term loss calculated on Form 8949 is then transferred to Schedule D, Capital Gains and Losses. Here, it is combined with any other capital gains and losses for the year. The bad debt loss can be used to offset any capital gains, and if a net capital loss remains, a taxpayer can deduct up to $3,000 of that loss ($1,500 if married filing separately) against other types of income.

Any loss exceeding the $3,000 annual limit is carried forward to future tax years. A detailed statement must be attached to the tax return explaining the loss. This statement must:

• Describe the debt, including the amount and due date.
• State the debtor’s name and any relationship to the taxpayer.
• Detail the efforts made to collect the debt.
• Explain precisely why the debt was determined to be worthless during that specific year.