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IRS sees some loans as gifts

Q: A couple years ago I was stupid and loaned an ex-friend $5,000 to keep his business going. Of course, that money is long gone and I’ve now realized I will never see it again. Can I deduct this on my next tax return?

A:  First, let’s go back to when you made the loan. Did you actually come to an agreement as to the term, the interest rate and the schedule for repayment of the loan? And was a written loan document created and signed by both you and your friend?

Typically, loans to friends are simply a transfer of money from one person to another without any of the formalities of a real loan. In these cases the IRS can argue that the “loan” was not really a loan, but a gift. This especially comes into play when the loan is between family members. It takes a good argument to establish the validity of the loan and the intent that the loan will be repaid if no formal document is in place, and even then the IRS may argue that a loan between friends was nothing more than a gift.

But assuming a valid lending relationship can be supported, you may have the opportunity to get some tax relief. In order for your loss to be deductible against your ordinary income, it would need to be classified as a “business bad debt.” While you may have made the loan to help a friend’s business, the loan was not made in the ordinary course of your business (unless lending money, like a bank does, is your business). Consequently, this loan would not qualify as a business bad debt, but would rather be considered a “nonbusiness bad debt.”

A nonbusiness bad debt can’t be taken as a tax deduction on your return until you are sure it is totally worthless. That means you have no hope of collecting the debt and that you no longer are even making efforts to collect. Once the debt is determined to be totally worthless, it should be reported as a short-term capital loss on Schedule D of your tax return for the year that the debt became totally worthless. Details as to the amount of the loan, the borrower’s name, the purpose of the loan and why the loan is totally worthless should be included in your return.

As a short-term capital loss, the loss can be used to offset other capital gains, plus an additional $3,000 per year can be deducted against your ordinary income. So, even if you have no other capital gain income, you will still be able to deduct the entire $5,000 loss over a two-year period – $3,000 this year and the remaining $2,000 next year.

 

Q: I sold some stock the other day and know I will need to report the sale on my tax return when it is filed. I bought the stock years ago but the original documentation for the purchase is buried somewhere in a storage unit. Can I just use my best guess as to my cost of the stock in reporting the gain?

A: The rules on determining cost basis in the tax law are horribly voluminous, but there is an underlying theme: You need to be able to substantiate the basis you report on your tax return to determine the taxable gain. This is often a problem when an investment was received by gift or inheritance, acquired via a nontaxable transaction or, as in your case, purchased years in the past.

Unfortunately, the IRS would argue that if you can’t substantiate your basis in the stock, then your basis is deemed to be zero. Consequently, the entire amount you received will be considered gain. Also there is the risk that if you can’t provide evidence of when the stock was purchased, the IRS may treat it as short-term capital gain rather than the preferable long-term capital gain subject to lower tax rates. While not applicable to your sale of stock, for Idaho tax purposes, certain capital gains are offered preferential tax treatment. Not being able to substantiate the basis and date acquired may result in loss of this benefit.

So my best advice is to go to the storage unit and look through all your records to see what you can find. I might also offer that using a good investment adviser to buy and sell your investments will help. Broker/dealers are subject to quite a bit of regulation and are required to keep and report basis information. Using an adviser may help you limit your document-hunting time in the future.

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To ensure compliance imposed by IRS Circular 230, any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities. The answers in this column are meant to offer general information. You should consult your tax adviser regarding the specifics of your situation.

Peter Robbins is a partner in the Boise office of CliftonLarsonAllen, LLP specializing in tax matters for small businesses, individuals, and trusts and estates.

Have a question for Robbins? Email your question to news@idahobusinessreview.com. Enter “Talking Tax” in the subject line.

About Peter G. Robbins, CPA

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