Deductions for bad debts generally take one of two forms on your tax return: business or nonbusiness. With some exceptions, you have a business bad debt when your loan-making activities are extensive and continuous enough to be considered a business.
As a general rule, you can deduct business bad debts in the year the debt becomes partially or fully worthless. You get an ordinary loss, not subject to capital loss limitations.
In contrast, a nonbusiness bad debt is deductible as a short-term capital loss. To deduct a nonbusiness bad debt, you have to show the debt became “wholly” worthless in the year you want to claim the deduction. Wholly worthless means the “last vestige of value” has disappeared, and the proof of that must be based in fact, not mere belief. For example, if the person who owes you money files for bankruptcy, you have an indication that at least part of the debt is worthless. However, to claim a deduction you may have to wait for settlement of the bankruptcy.
In T.C. Memo. 2015-191 (Cooper/Brady), the taxpayer, who worked at a health sciences company for fourteen years as a full-time employee and owned several business interests, also loaned money to friends and acquaintances referred to him by friends. Between 2005 and 2010, he made 12 loans to 11 borrowers on a short-term, high-interest-rate basis. The taxpayer did not conduct credit checks, verify collateral through title searches, or collect information through loan applications.
In 2006, he loaned $750,000 to a real estate development company owned by an acquaintance. The promissory note reflected a maturity date of September 29, 2006 and included a collateral guaranty in the form of a deed of trust on real property owned by the development company. No lien was recorded. In October 2006 the taxpayer extended the loan for an additional six months. The taxpayer and the development company signed a successor promissory note for $925,000 which reflected an unpaid $750,000 principal plus the interest due.
In April 2007 when the $925,000 came due, the development company did not pay. The company filed a chapter 11 bankruptcy petition (for reorganization) in 2008. The bankruptcy estate’s schedules initially reported assets of $62,480,203 and liabilities of $34,571,185 in July 2008 and later reported assets of $61,180,203 and liabilities of $26,698,931 on its amended schedules filed in August 2008. The taxpayer never filed a proof of claim with the bankruptcy court.
In 2009, a bank filed a proof of claim against the bankruptcy estate for $42,473,310. The bank claimed a mechanic’s lien that was an asset of the bankruptcy estate was overvalued, that the bankruptcy estate was currently operating with negative cash flows, and that the bankruptcy estate’s liabilities should have included additional liabilities. The bank requested that the bankruptcy be changed to a chapter 7 (liquidation) bankruptcy, and the request was granted.
In February and April of 2009, the taxpayer listed the loan as an asset on a net worth statement. In October 2009 when he filed his 2008 tax return, he did not report the loan as worthless.
The true value of the mechanic’s lien was determined in 2010 when the bankruptcy court authorized it to be sold. Sometime after April 2010, the lien was sold for $116,000, a fraction of what it had been valued at on the previous bankruptcy schedules. The bankruptcy proceedings were closed in August 2013.
The taxpayer filed an amended 2008 return reporting the bad debt in April 2010 and claimed a business bad debt deduction for the loan of $750,000.
The IRS disallowed the deduction, saying the taxpayer was not in the business of loaning money.
The court agreed with the IRS.
However, because the loan could potentially be deducted as a non-business bad debt, the question became whether the loan was wholly worthless in 2008.
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The first instance of the taxpayer treating the loan as worthless wasn’t until 2010, when he filed an amended return, retroactively treating the loan as worthless for 2008.
The taxpayer failed to show that he abandoned hope of recovery in 2008; but moreover, the evidence does not establish that the debt was wholly worthless at that time. The key is that the debt must be wholly worthless.
The taxpayer points to the development company filing bankruptcy in June 2008 as proof, but this did not establish with reasonable certainty that the debt was wholly worthless. The company filed for chapter 11 reorganization and reported positive net worth on its bankruptcy schedules as of 2008.
Editorial note: The taxpayer also argued the debt was worthless in 2009, but the court disagreed with that conclusion also, saying,
Similarly, the taxpayer has not established that the debt was wholly worthless in 2009. The taxpayer points to speculation in the bankruptcy proceeding of asset overvaluation, claims of additional liabilities, and the conversion to a chapter 7 case as proof that the debt became wholly worthless in 2009.
These allegations do not establish the values of the assets and liabilities of the bankruptcy estate as of 2009. Therefore, the taxpayer has not met the burden of showing that the debt became wholly worthless in 2009.
As of the end of 2009 the value of the mechanic’s lien was unknown. The mechanic’s lien was the largest asset of the bankruptcy estate and had been reported on the original schedules with a value of approximately $36,500,000. It was not until 2010 that the value of the lien was known, which is also when the taxpayer first treated the debt as worthless (when he filed his amended return for 2008).
Therefore, we hold that the taxpayer cannot deduct the bad debt for 2008 or 2009.