So, your best friend needs a loan to get a cheap car. You agree to give him $5,000 and he will pay you back in a year. At least that is the agreement. How do you handle taxes and personal loans. Most of the time when it comes to family and friends, we don’t think of the formalities that must take place in order for the IRS to consider this a real loan. Why do you need this anyway I mean you trust him or her to pay you back right?
The reality is we often do loans knowing they will never get paid back. I mean this person is coming to you because they either can’t or won’t get a traditional loan and the hard money lenders don’t deal with amounts that small unless they specialize in micro-loans which very few investors do. When they can’t pay you back and you want to write it off on your taxes is when all this documentation comes into play.
Before making that loan make sure you have in writing that you are making a loan. It needs to have the name of the person you are giving the loan to along with their address and federal ID number. You need the amount of the loan, the interest rate and when they are supposed to pay you. This does not have to be a formal agreement, but it does need to be written and both of you need to sign and date it.
Keep in mind that the interest is taxable income in the year you receive the interest. On the other hand if they do not pay you back and you decide to write it off as a loss on your taxes you have several restrictions because it is considered a personal loan unless you have a business where you do more than one of these types of loans on a regular basis. As a personal loan it is treated similar to a casualty loss for tax purposes. The amount is reduced by $400, not only that but if you do take them to small claims court those legal expenses cannot be written off as they are considered personal.
From here it is considered either a short-term or long-term (normally long-term) loss and is capped at $3,000 with anything not used carrying forward each year until it is used up. That loss can be used to reduce other gains but only the $3,000 can be used against other types of income.
If you need some help determining how to treat a loan. Schedule a time and we would be happy to talk w
ith you.