Write off Bad Debt Before Friend Tries to Pay Me?

Dear Tax Talk, I'm lending a friend $30,000 to start a small business. We have a promissory note that states the terms of repayment and interest.

As far as taxes go, can I write off the full $30,000 in the first year against short-term capital gains? I know this is true for bad debt, but what if the payments are made on time (which hopefully will be the case)?

I would prefer to write off the whole amount in year one and pay tax on the full monthly payments rather than just paying taxes on interest throughout the life of the loan while slowly regaining the principal. Can I claim a bad debt write-off right away?

-- Cody

Dear Cody, It seems like you have opposing objectives here. You'd like to get repaid, but you'd rather have an immediate write-off without even trying to get paid. Well, I can tell you the latter won't happen that easily. To claim a bad debt write-off, you have to go through some hoops.

When you lend money to a friend, you must have a clear intention the loan will be repaid. Otherwise, it would be considered a gift. You cannot take a bad debt deduction for a gift. There cannot be a bad debt unless there is a true creditor-debtor relationship between you and the person or company that owes you the money. This means you should set up some substance to the loan such as invoicing for the loan payments, sending email reminders and charging penalties for late payment. If the loan does go south, you should make genuine attempts to collect the debt such as turning over the matter to an attorney.

Until you determine the debt to be worthless, you cannot claim a deduction. You do not have to get a court judgment to show the worthlessness of the debt if you can show the judgment would be unnecessary -- for example, if the debtor were to be worthless, bankrupt or out of business.

For these reasons, you cannot claim the loss at your own choosing.

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