Can You Deduct a Personal Loan Loss on Your Taxes?

Lending money to a friend or family member is often done with the best of intentions. But what happens when that loan goes unpaid, leaving you faced with the dual frustration of lost money and potential awkwardness in your relationships? Did you know that under certain conditions, you might be able to deduct that loss on your taxes? Understanding how to manage a personal loan loss in terms of your finances can make a difficult situation a little easier to bear.

This blog outlines everything you need to know to determine whether you can deduct your loan loss, the IRS rules involved, and how to properly document the situation to benefit from it.

When Does a Personal Loan Loss Become a Tax Deduction?

Not all unpaid personal loans qualify for a tax deduction. For the IRS to approve the deduction, the debt must meet certain criteria, meaning it needs to pass the "bad debt" test.

What is Bad Debt?

The IRS defines bad debt as a debt that was created with the intent to collect repayment but becomes entirely worthless. This suggests the loan has no chance of being repaid—whether the borrower ran into financial trouble, declared bankruptcy, or simply disappeared.

When it comes to bad debt deductions, there are two main categories to be aware of:

1. Business Bad Debt - This type applies to loans related to your business operations.
2. Nonbusiness Bad Debt - This category covers personal loans. Since lending money to relatives or friends falls under this category, we'll focus here.

Nonbusiness Bad Debt and Its Deductibility

To qualify as a deductible nonbusiness bad debt, the following conditions must be met:

• The Loan Was Genuine - You must have created a real debtor-creditor relationship with the expectation of repayment. A casual loan without clear terms likely won’t qualify.
• It's Completely Worthless - You can’t deduct partially unpaid loans. The debt must be fully worthless, with zero expectation of repayment.
• It’s a Loan, Not a Gift - If the IRS determines your “loan” was actually a gift, you won’t be able to claim the loss as a deduction. We'll talk more about this distinction below.

Common Pitfalls to Avoid

Before claiming a personal loan loss as a deduction, there are a few common traps taxpayers fall into that can result in denied claims.

Mistaking a Gift for a Loan

If you lent money without formalized terms—such as a signed promissory note, set repayment schedule, or interest rate—the IRS might classify the money as a gift. To strengthen your claim, always document the loan in writing, detailing the amount, repayment terms, and any applicable interest.

Lack of Evidence

The burden of proof lies on you to show the loan has become worthless. This can include showing that:

• The borrower declared bankruptcy.
• Collection efforts failed.
• The borrower is unreachable or has no assets worth pursuing.

Without clear evidence, the IRS may challenge your deduction claim.

Forgetting the Timeline

A nonbusiness bad debt is deductible only in the year it becomes completely worthless. If you wait too long or prematurely write it off before there’s concrete evidence that the loan is uncollectible, you risk losing the deduction.

How to Document and Claim a Personal Loan Loss

Tax rules can quickly become complex, especially in situations involving personal loans. Here’s a step-by-step guide to help you stay on track and meet the IRS’s requirements.

Step 1: Formalize the Loan Agreement

Always start with a written, signed document outlining the following:

• Amount lent.
• Interest rate (if any).
• Repayment terms (due dates and payment amounts).

This agreement will prove to the IRS that your loan was a legitimate financial arrangement and not a gift.

Step 2: Make Reasonable Attempts to Collect

Before assuming the debt is worthless, show that you made sincere efforts to recover the loan.

• Send reminders and notices.
• Consider pursuing legal action in small claims court.

These efforts will also serve as evidence should the situation reach the IRS.

Step 3: Determine Worthlessness

The point at which the debt becomes worthless depends on specific circumstances. For example:

• If the borrower declares bankruptcy, the debt may be considered worthless as soon as court documents confirm no repayment is possible.
• If the borrower is unreachable, document your attempts to track them down.

Step 4: Report the Loss on Form 8949

Once you’re certain the debt is worthless, you can claim the deduction by filing Form 8949 (Sales and Other Dispositions of Capital Assets) with your return.

Nonbusiness bad debts are treated as short-term capital losses. This means they are subject to capital loss limitations, but they can offset capital gains and even reduce up to $3,000 of your regular income annually.

Step 5: Keep Detailed Records

Stay prepared in case of an IRS audit by maintaining copies of:

• The loan agreement.
• Evidence of your collection attempts.
• Bankruptcy filings or other proof of worthlessness.

Is It Worth the Deduction?

Claiming a personal loan loss as a deduction can help ease the financial burden, but it won’t recoup 100% of your lost money. For many taxpayers, the actual tax savings may only be a fraction of the loan amount. Still, it’s worthwhile to claim what you’re legally entitled to recover.

For example, if the unpaid loan amount was $5,000 and you’re in the 24% tax bracket, the deduction could save you about $1,200 in federal taxes—not a full recovery, but certainly helpful.

Legal and Tax Advice Can Make the Process Easier

Navigating personal loan losses, tax forms, and compliance often feels overwhelming—but you don’t have to do it alone. Tax laws surrounding bad debts are nuanced, and missteps can lead to unfavorable outcomes with the IRS.

At SD Mayer & Associates, we specialize in helping taxpayers tackle complex financial and tax-related challenges. Whether you need help formalizing a loan, documenting collection efforts, or ensuring you meet all tax reporting requirements, our team is here to help you every step of the way.

Get Professional Help for Your Tax Deductions

With proper documentation and compliance, you can turn a loan loss into modest tax savings. Our experienced team at SD Mayer & Associates makes tax planning and navigating complex documentation much simpler. Contact us today, and take the first step toward reclaiming your lost financial clarity.

Still have questions about deducting a personal loan loss? Reach out for expert advice—we’re here to help!