Bad Debts – Family Loans
If you made an ill-advised loan to a family member, the saving grace is that you’re allowed to claim a nonbusiness bad-debt deduction.
Your write-off is considered a short-term capital loss. So you can use it to shelter your capital gains for the year. If the loss exceeds your gains you can write off another $3,000 against other income. ($1,500 for married filing separate status). Any remaining loss is carried forward to future tax years, when it can be deducted under the same rules.
To claim a deduction, you must show that it’s impossible to collect the loan. But you don’t need to file a lawsuit or hire a collection agency to harass your relative.
Instead, do this: Make a written demand for repayment. When that fails to produce results, write a memo to your tax file to document that your tried and failed to collect. It also helps if you can gather financial information that shows the borrower is insolvent. Claim your nonbusiness bad-debt deduction in the year you determine the loan worthless. (No deduction is allowed for partially worthless loans).