One redeemable quality about humans is that we tend to be more willing to loan money than borrowing it. No one really likes to borrow money, but if a friend is in need, many of us help as much as our financial means allow. When this occurs, it is important to understand that there are income tax consequences for both lenders and borrowers when interest is earned, paid or forgiven on a loan. This blog will address the tax consequences of unpaid loans.
For tax purposes, a loan’s most important components relate to its principal, interest and tax basis. A loan’s principal is the amount of money loaned, and the loan’s interest is income earned by the lender for making the loan. A loan, like other investments, has a tax basis, which is the principal or amount loaned. It normally consists of the original amount of the investment or loan and any costs incurred. Of course, the value of this tax basis is not taxed.
Typically, any income generated from a loan constitutes taxable income and must be reported on your tax return. This income is simply the interest earned on the loan for the current tax year. But what if the loan is unpaid and no income is ever generated in the form of interest?
If a loan is unpaid, a lender may be allowed to take a deduction, provided that the transaction is arms-length and sufficiently documented. According to the IRS, “For a bad debt, you must show that there was an intention at the time of the transaction to make a loan and not a gift. If you lend money to a relative or friend with the understanding that it may not be repaid, it is considered a gift and not a loan.” As for individuals that are cash-basis taxpayers, bad debt deductions are available only for money received as income and then loaned. It doesn’t apply to money received for services rendered.
Typically, if a loan is forgiven, the amount forgiven is treated as income to the borrower, who must report it on his or her tax return. If a loan is provided at an interest rate below a rate set by the IRS, it may be subject to rules regarding below-market loans, and interest may then have to be treated as income. If you have capital gains, you can use the bad loan to offset these gains. These rules are complex and require the assistance of a tax professional.
If you are an individual or business in the New York or Tri-State area and have any question about taxes, especially in planning ahead for the next filing season, call THE TAX EXPERTS at the Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation call 212-490-0704. 
