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Tax Guy: How to write off bad-debt losses

The issue of deducting bad debt losses has been a continuing source of controversy between individual taxpayers and the IRS for decades. Even so, you may be entitled to a tax write-off if you made what turned out to be an ill-fated loan to another party. Here’s what you need to know.

Bad-debt deduction basics

The IRS is always skeptical when individual taxpayers claim deductions for bad-debt losses. The reason: Losses from purported loan transactions are often from some other type of deal that went south. For example, you might have actually made a contribution to the capital of a business entity that turned out to be a loser. Or you might have advanced cash to a friend or relative with the unrealistic hope that you would be repaid without having anything in writing.

So to claim a deductible bad-debt loss that survives IRS scrutiny, you must be prepared to prove that the loss was actually from a soured loan transaction instead of some other ill-fated financial move.

Proving you made a loan

Over the years, the courts have identified the following factors as being relevant in proving that you made a bona fide loan.

1. Written loan document. If you don’t have one and get audited, you can pretty much kiss away any chance for claiming a bad-debt loss deduction.

2. Descriptions in other documents (for example, showing a loan receivable on your personal balance sheet).

3. Presence of a stated interest rate and a stated maturity date in the loan document.

4. Source of funds to repay the loan.

5. Your right to enforce repayment.

6. Intent of you and other party.

7. Borrower’s ability to obtain loans from other lenders.

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Tax Guy: How to write off bad-debt losses

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