Can you take a tax write-off for money loaned to your children that is never paid back?
jada diedrich, wealth advisor, buckingham strategic wealth
While it is possible to deduct bad debt from a relative, these transactions are heavily scrutinized by the IRS. It can be difficult to prove the intent was a loan and not a gift, so it is very important to consult a tax professional from the beginning to ensure you properly structure, administer and report the loan. There must be a written promissory note that details the loan amount, interest rate, payment terms and collateral. The note should be signed and copies retained by all parties. It is also important for payments of interest and principal to be made each year. The interest rate should be fair and equal to what you would charge a stranger; it must be at least the Applicable Federal Rate (AFR) to be considered ‘at arm’s length.’
One strategy is to forgive a portion of the principal each year until the borrowed amount is completely gone, but these transactions should be properly structured and administered. A gift tax return should be filed each year, and the interest income should be reflected on your tax return. Your children may be able to take a deduction for the interest paid if the purpose qualifies.
If the family member does default on the loan, it may be possible for you to deduct the loss. However, the IRS will examine this closely. You must be able to show that the loan was properly structured and you attempted to enforce payment and pursued collection.
doug mueller, president mueller prost cpas + business advisors
We’ve all loaned money to our kids with the promise they’d pay us back, and we usually never see that money again. But as a taxpayer, can you write off the loss? It depends. The IRS will always scrutinize ‘loans’ between family members. Several tax and district court cases have indicated nine factors that determine whether a disbursement is a loan or a gift. They are:
1. existence of evidence of a debt
2. existence of a fixed schedule for repayment
3. Interest is charged on the debt
4. Collateral is requested
5. existence of a written agreement
6. demand for payment is made
7. records that reflect all of the above
8. repayments have been made
9. the debt of insolvent at the time of the loan
Most of these factors are helpful, if not necessary, to convince the IRS the taxpayer truly has a loan arrangement and the money was not a gift. It goes without saying that having written evidence of the debt is key.
If a family member is successful in showing that this is a valid indebtedness, the best you can hope for is a nonbusiness bad debt, which means a capital loss, not an ordinary deduction. The capital loss would only be available to offset capital gains, or the taxpayer would get at most a $3,000 deduction in any given year.
There are many factors that affect parent-to-child loans and estate planning, so always consult a CPA for questions on tax matters.