Key Takeaways
A loan to your child may qualify as a non-business bad debt if it was a legitimate loan with an enforceable obligation to repay, not simply money you gave your child with no real expectation of repayment.
The debt must become completely worthless before you can deduct it. Unlike certain business debts, you generally can’t deduct only the portion of a personal loan you don’t expect to recover.
Documentation matters. A written loan agreement, repayment schedule, records of payments, collection attempts, and other evidence can help establish that the transaction was intended to be a loan rather than a gift.
IRS Requirements For Non-Business Bad Debt
The fact that your child hasn’t repaid you doesn’t automatically make the money tax-deductible. The IRS distinguishes between a legitimate loan that later becomes worthless and a gift that was never realistically expected to be repaid.
According to IRS Publication 550, a genuine debt must arise from a debtor-creditor relationship involving a valid and enforceable obligation to repay a fixed or determinable amount of money. When money is provided to a relative or friend with the understanding that repayment may never occur, the IRS may consider the transaction a gift instead of a loan. Gifts don’t qualify for the bad debt deduction.
Several factors can therefore become important when determining whether a family loan qualifies.
There Must Have Been an Intent to Repay
At the time you provided the money, both you and your child should have understood that the money was expected to be repaid. A written promissory note or loan agreement can provide strong evidence of this arrangement.
Ideally, the agreement should document details such as:
- The amount borrowed
- The repayment schedule
- The interest rate, if applicable
- The loan’s due date or term
- What happens if payments aren’t made
Keep in mind that interest-free and below-market family loans can have additional tax consequences. The IRS has rules governing certain below-market loans, and lenders may sometimes be required to recognize forgone interest as income.
The Debt Must Be Completely Worthless
A non-business bad debt must be totally worthless before you can claim the deduction. You can’t simply determine that you’re unlikely to receive the entire balance and deduct the portion you don’t expect to collect.
Generally, a debt becomes worthless when there is no longer a reasonable chance that it will be repaid. Circumstances that could help demonstrate this might include the borrower’s bankruptcy, prolonged financial insolvency, or unsuccessful attempts to collect the debt.
You aren’t necessarily required to sue your child to establish that the debt is worthless. The IRS states that going to court isn’t necessary if you can show that a judgment would be uncollectible. However, you should be able to demonstrate that reasonable efforts were made to collect the debt.
You Must Have a Basis in the Debt
You also need a tax basis in the debt. For a typical family loan, this generally means that you actually loaned your child cash or other funds for which you have a basis. You can’t claim a deduction simply because someone failed to pay you money that was never included in your income or otherwise gave you a tax basis in the debt.
It’s also important to note that the IRS specifically states that money provided by parents to minor children for their basic needs doesn’t create a genuine debt for purposes of the bad debt deduction.
How the Tax Write-Off Works
If your child’s loan meets the IRS requirements and becomes completely worthless, the deduction generally isn’t treated like an ordinary expense. Instead, a non-business bad debt is reported as a short-term capital loss, regardless of how long the debt was outstanding.
The loss is generally reported on Form 8949, Sales and Other Dispositions of Capital Assets, and then flows through to Schedule D. On Form 8949, the IRS instructs taxpayers to identify the debtor and indicate that a bad debt statement is attached.
You’ll also need to attach a statement explaining the debt. According to IRS guidance, that statement should include:
- A description of the debt, including the amount and when it became due
- The debtor’s name and your family or business relationship
- The steps you took to collect the money
- An explanation of why you determined the debt was worthless
Because it’s treated as a capital loss, the deduction is subject to the normal rules and limitations that apply to capital losses. That means the amount of the loan doesn’t necessarily translate into an equal reduction in your taxable income for that year.
Example
Suppose you loaned your adult daughter $20,000 under a written agreement requiring monthly payments. She made payments for a period of time but later experienced severe financial difficulties. After reasonable collection attempts, she declares bankruptcy, and the facts establish that there is no reasonable chance you’ll recover any of the remaining $15,000 balance.
If the loan qualifies as a bona fide debt and becomes completely worthless during that tax year, the remaining $15,000 could potentially qualify as a non-business bad debt and be reported as a short-term capital loss.
The result could be very different if you originally gave her $20,000 and told her to “pay it back whenever you can.” If there was never a genuine expectation or enforceable obligation to repay the money, the IRS could view the transaction as a gift rather than a loan.
What to Do If You Didn’t Get It in Writing
Family loans aren’t always handled as formally as bank loans. You may have transferred money to your child with a clear expectation that it would be repaid but never created a promissory note or written loan agreement.
Not having a written agreement can make establishing a bona fide debt more difficult. The central question remains whether a genuine debtor-creditor relationship existed. IRS guidance focuses on whether you intended to make a loan rather than a gift and whether you had a valid obligation to repay.
If you don’t have a formal agreement, gather any documentation that could help demonstrate what both parties intended when the money changed hands. This could include:
- Bank records showing the original transfer
- Emails or text messages discussing the loan
- Records of previous payments your child made
- Messages discussing repayment dates or amounts
- Evidence that you requested repayment
- Records showing how much remains outstanding
- Other communications demonstrating that your child acknowledged owing you the money
Be cautious about creating a loan agreement after the fact and treating it as though it existed when the money was originally transferred. Documentation created later may help clarify an existing obligation, but it doesn’t necessarily transform what was originally a gift into a bona fide loan.
Because family transactions receive additional scrutiny and the facts of each arrangement can differ substantially, consider consulting a tax professional before claiming a large non-business bad debt without formal loan documentation.
FAQs
Final Thoughts
You may be able to write off an unpaid loan to your child, but simply calling the money a “loan” isn’t enough. To qualify for a non-business bad debt deduction, you generally need to establish that there was a genuine obligation to repay the money and that the debt became completely worthless during the year you’re claiming the deduction.
Family loans can also create other tax considerations, particularly when large amounts are involved, the loan doesn’t charge adequate interest, or you ultimately decide to forgive the balance. Good documentation from the beginning can make a significant difference. If you’re unsure whether an unpaid family loan qualifies for a deduction, a qualified tax professional can review the arrangement and help determine the appropriate way to report it.