Bad Debt Write-Off Allowed For Family Loan
In a recent Tax Court case (McFadden, T.C. Memo.2002-166), the court allowed a parent to claim a bad debt write off of more than $130,000.00 for a loan to his daughter that was used to buy a house.
A bad debt deduction may be available if a taxpayer has loaned money to others or has included in gross income debts due from others for property sold or services rendered. The loss resulting from the worthlessness or uncollectibility of these debts is deductible. (IRC Sec. 166).
Bad debts come in two varieties: business and nonbusiness. A business bad debt, generally, is one that comes from operating a trade or business and is deductible as an ordinary business loss [Reg. 1.166-5(b)]. All other bad debts are nonbusiness bad debts and are deductible as short-term capital losses [Reg. 1.166-1].
EXAMPLE An architect made personal loans to several friends who were not clients. She could not collect on some of these loans. They are deductible only as nonbusiness bad debts because the architect was not in the business of lending money and the loans do not have any relationship to her business.
A business bad debt need not be completely worthless before a deduction is claimed. If a debt becomes partially worthless, taxpayers can deduct the portion that they charge off on their books for the year [Reg. Sec. 1.166-3(a)]. However, that’s not true for nonbusiness bad debts. To be deductible, nonbusiness bad debts must be totally worthless. A taxpayer cannot deduct a partly worthless nonbusiness debt. This is one of the common areas of disputes in intrafamily loans. Was the child’s debt truly worthless when the parent claimed the write-off?
A debt becomes worthless when there is no longer any chance that the amount owed will be paid.
It is not necessary for taxpayers to go to court if they can show that a judgment from the court would be uncollectible. They must only show that they have taken reasonable steps to collect the debt. Bankruptcy of the debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt.
Another issue in intrafamily loan disputes in the genuineness of the loan. A debt must be bona fide for a deduction to be allowed. A debt is genuine if it arises from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum o money. For an intrafamily loan, the parent must be able to show that there was an intention at the time of the transaction to make a loan and not a gift. It a parent lends money to a child with the understanding that it may not be repaid, it is considered a gift and not a loan.
Some of the factors courts consider when determining whether there is a debtor-creditor relationship between family members are whether:
- There is a note or other evidence of indebtedness;
- Interest is charged;
- There is a fixed schedule for repayment;
- Security or collateral is requested;
- There is any written loan agreement;
- A demand for repayment has been made;
- The parties’ records reflects the transaction as a loan;
- Repayments have been made; and
- The borrower was solvent at the time of the loan.
In 1989, Stephanie McFadden and her boyfriend, David Payne, wanted to buy a house in Atascadero, California, but neither had the financial ability to do so. They wanted to live in the house, refurbish it, and eventually resell it. Stephanie asked her father, Wayne McFadden, an attorney in San Mateo, California, to help the couple finance the purchase of the house and subsequent improvements. Wayne believed that Stephanie had real estate talent, and that David’s craft skills provided an opportunity to enhance the value of the property at a minimal labor cost.
In January 1990, Wayne made the first in a series of 33 loans totaling $160,701 to Stephanie and David at an interest rate of 12%. The loans were made over an 18 month period ending in August 1991.
On February 14, 1990, Stephanie and David purchased the home for $225,000.00 with Stephanie acquiring an 80% interest and David a 20% interest. Stephanie and David financed the purchase of the Atascadero house by obtaining a $180,000 loan from the Great Western Bank in exchange for a first mortgage on the property. The balance of the purchase price was financed by loans from Wayne.
After making substantial improvements, Stephanie and David listed the home for sale on April 19, 1991, at an asking price of $449,500. The asking price remained $449,500 for approximately three months, but failed to generate any offers. Stephanie and David reduced the price to $379,500 in July 1991. Despite the reduction, the home still failed to generate any offers. Stephanie and David were unwilling to reduce the price further and took the property off the market in August 1991 with the hope that marked conditions would improve.
On August 30, 1991, Stephanie and David consolidated the 33 loans by executing a single note secured by a second mortgage. The note fell due in 24 months.
Stephanie and David made unsuccessful attempts to sell the Atascadero house at different times over the next 2 years. In 1993, Stephanie and David ended their relationship.
In 1994, Stephanie purchased a house in Oakland, California and moved in, along with her mother. In the beginning of 1995, Stephanie accepted a job in Dallas, Texas. Stephanie lived in a rented apartment in Texas for more than half of 1995, continued to make the mortgage payments on her home in Oakland and made payments on the Great Western loan on the Atascadero house. David did not make any payments on the Great Western loan.
By the summer of 1995, Stephanie was experiencing financial difficulties from having to make 3 monthly payments. Stephanie informed Wayne that she could no longer continue making payments on the Great Western loan and was going to default. Wayne became concerned that he would lose his security interest in the Atascadero house if Great Western foreclosed on the first mortgage. When he asked Stephanie about the other assets our of which his note could be satisfied, Stephanie told him she had “nothing.” During their conversations, Wayne learned that Stephanie was contemplating filing for bankruptcy protection. Wayne also had conversation with David about the debt and Wane concluded that David was not in a position to make payments.
In August 1995 Wayne accepted a deed from Stephanie and David in lieu of foreclosure on the Atascadero house. The fair market value of the Atascadero property was $207,500 at the time the deed was executed. The outstanding balances on the loans from Great Western and Wayne were $168,957 and $170,371, respectively. At the time the deed was conveyed to petitioner, neither Stephanie nor David had made any principal payments on the Atascadero loan.
On December 29, 1995, Wayne finally sold the Atascadero house. Also on December 29, 1995, Stephanie sold her Oakland home. In 1995, Stephanie also purchased a house in Dallas, Texas, which she sold in 1996 for a gain of $45,401. Stephanie earned $87,148 and $100,744 in 1995 and 1996, respectively.
When Wayne claimed a nonbusiness bad debt deduction for 1995 the IRS disallowed it, and Wayne took his case to the Tax Court.
The Tax Court allowed a bad debt deduction of $131,828. That’s the difference between the $170,371 balance on his loan and the $38,543 that he would have received had Stephanie sold the home for $207,500 and paid off the Great Western mortgage. The court held that the debt was genuine and became worthless in 1995.
The court said that there was sufficient proof to indicate that a true debtor-creditor relationship existed between Wayne and Stephanie and David. The loan was evidenced by a note executed by Stephanie and David in favor of Wayne; the note was secured by a second mortgage, and interest was charged at a rate well above the market rate.
As to the worthlessness issue, the court noted that in 1995, Stephanie was in dire economic straits from having to service both the Great Western loan and the loan on her home in Oakland, as well as pay rent on an apartment in Texas. Stephanie informed Wayne that she had to keep her apartment in Texas where she lived and worked, and that she was unwilling to evict her mother to sell the Oakland home. Her only option was to cease making payments on the Great Western loan. Stephanie’s financial condition had deteriorated to the point where she was contemplating filing for bankruptcy.
The court said that it was “unmoved” by the IRS’s argument that Stephanie’s income in 1996 would have enabled her to make payments to Wayne. “A taxpayer is not required to wait until some turn of the wheel of fortune may being the debtor into affluence.”
CLAIMING NONBUSINESS BAD DEBT WRITE OFFS
Taxpayers deduct nonbusiness bad debts as short-term capital losses on Schedule D (form 1040). In Part I, line 1 of Schedule D, the name of the debtor is entered and “statement attached” is entered in column (a). The amount of the bad debt is entered in parentheses in column (f). Attached to the return is a statement containing the following information:
- A description of the debt, including the amount, and the date it became due,
- The name of the debtor, and any business or family relationship between the taxpayer and the debtor,
- The efforts the taxpayer made to collect the debt, and
- Why the taxpayer decided the debt was worthless.