These being the times they are, you may be tapped for loans by relatives or friends who are unable to come up with the down payment for a home or who wants to start a business or keep it afloat. What if a loan goes sour, as so often happens? The tax rules on deductions for bad debts can be more bad news for you.
Although you can deduct a worthless loan if there’s no likelihood of recovery in the future, you can’t take a deduction for an outright gift. That's why the IRS looks closely at bad debt deductions where the lender and borrower are related and why it may insist on proof that the "loan" wasn’t really a gift.
Unpaid loans and marriage. The law presumes that loans from one spouse to another don’t create valid debts. To get around that snag, Carolyn Marlett claimed that her marriage to husband Charles was a "relationship maintained for financial convenience only." Hence, her co-signing of a joint income tax refund was a loan to Charles, as were her other "advances" to him.
However, Carolyn couldn’t convince the U.S. Tax Court that the advances were valid debts. In a 1976 decision, the court noted that she never asked Charles to sign notes or bothered to set an interest rate or repayment schedule.
But the court isn’t completely inflexible on this issue. It ruled that June M. Rogers could deduct loans made to her husband, who declared bankruptcy after their divorce. The loans weren’t gifts; he used the money in an unsuccessful business venture and signed promissory notes for repayment.
Unreturned engagement ring. The Tax Court ruled in favor of the government in 1982 in a case involving Jack Wolfson. Jack was a Dallas salesman whose territory included Houston, where he met and ultimately became engaged to Yvonne Gibbs.
To seal their engagement, he gave her a diamond ring. But just a week later, she broke things off and sold the ring, a decision triggered by Jack's refusal to honor his promise to reimburse her for the cost of housing her poodle in a kennel during her visits with him in Dallas. Jack sued Yvonne for the ring's cost and won a default judgment of $1,000, which he made no attempt to collect. Instead, the spurned lover took a bad debt deduction for $1,000.
The IRS invoked two arguments to justify its disallowance of the deduction. First, Jack didn’t offer any proof he tried to collect. Therefore, the debt wasn’t worthless at the end of the year in issue, a requisite for the write-off of a bad debt. Second, simply giving an engagement ring doesn’t create a debt. Approving a bad debt deduction for that act alone "would, in essence, open the doors of litigation to allow every rejected lover to come into the Tax Court and ask it to allow him a deduction" for an unreturned ring.
The IRS urged the court not to assume "part of the cost of the romance" of Jack with Yvonne. The judge deemed it unnecessary to rule on the second argument, as he agreed with the first one. Jack offered no evidence of Yvonne's insolvency or other inability to pay during the year in question. Hence, he failed to prove the debt's worthlessness during that year.
The bottom line? If it’s a loan, especially to a close friend or relative, make sure the paperwork and process show it’s a bona fide loan and not a thinly disguised gift.
Julian Block writes and practices law in Larchmont, N.Y. and was formerly with the IRS as a special agent (criminal investigator) and an attorney. He is frequently quoted in the New York Times, the Wall Street Journal, and the Washington Post, and has been cited as: “a leading tax professional” (New York Times); "an accomplished writer on taxes" (Wall Street Journal); and "an authority on tax planning" (Financial Planning Magazine). This article is excerpted from “Julian Block’s Tax Tips for Marriage and Divorce,” available as a Kindle at Amazon.com and as a print copy at julianblocktaxexpert.com. Law professor James E. Maule of Villanova University praised the book as “An easy-to-read and well-organized explanation of the tax rules.” The National Association of Personal Financial Advisers says it is “A terrific reference.”