Gary Bode CPA: tax planning can help maximize your personal bad debt tax deduction. For a free phone consult please call 399-2705.
A common personal bad debt scenario involves loans made between family members. Beneath the example below, I discuss how to optimize tax deductions for all the parties involved.
With the recession, most CPAs field questions on the bad debt tax deduction. Every case is different, so you can’t rely on this post alone. How do bad debt CPAs get their info?
- From the tax code itself.
- Professional interpretations of the tax code.
- Experience.
- Tax court cases.
- IRS instructions, in this case IRS Publication 550.
What can’t be deducted?
Common issues that aren’t deductible include:
- Unpaid child support.
- Uncollected rent.
- Unpaid wages or salaries.
- Debts from political parties and campaigns.
How to Qualify for the Personal Bad Debt Tax Deduction -using a loan as an example
- The loan can’t be business related. Please see the link above for a business related bad debt.
- The debt is bona fide, e.g., the loan was not a gift and you expected repayment.
- You have a basis in the debt, e.g., you made the loan from money you already paid taxes on.
- The debt became totally worthless in the year you claim the deduction. Partial bad debts aren’t deductable. You can only claim the deduction in the tax year the loan became entirely worthless.
Example: a loan to your Sister for a home down payment
- You gave a $10,000 loan to your Sister and she never repaid you. This sounds like a gift and isn’t deductible.
- You loaned you Sister $10,000 in 2011 and she signs a note laying out repayment terms. Two years later she defaults on the house. You know the $10,000 will never be repaid. The $10,000 is deductible on your 2013 Form 1040.
How can a Bad Debt CPA Help Myself and my Sister?
Timing is crucial in both cases.
Your Sister-
Once your Sister defaults on the house, the $10,000 of cancelled debt from the loan becomes taxable income for her in 2013. Why? Because you have to report her to the IRS as the bad debt recipient. In some cases, maybe that’s what you, as the lender, want. But with familial coordination and tax expertise, your Sister might be able to exclude the $10,000 of cancelled debt from her income in 2013. So, she would have no tax consequences from you claiming the bad debt deduction. Please click on Form 982 in the left sidebar for multiple posst on cancelled debt.
You, as Lender-
Capitol loss limitations govern your bad debt deduction. Careful tax positioning might overcome this limitation. Timing is crucial.
Did you Miss a Deduction?
You can amend a prior tax return, within certain time limits, to claim the bad debt and generate a tax refund.
Bad Debt Tax Deduction Logistics
The actual deduction flows through Schedule D to Form 1040. It is subject to the capital loss limitations. Careful documentation must be included with your tax return.
We’re a bad debt CPA firm in Wilmington NC that services a large geographical base through our Virtual Office. For a free initial phone consult, please call (910) 399-2705.
