Most financial professionals recommend people avoid giving loans to family members. Relationships become messy when the borrower misses a payment or does not pay the loan back. However, many people do give loans to family. The family member who provides a loan to someone to start a business should treat it like an investment. This should be a business decision made after the person lending the money writes out the terms of the loan in a contract. The IRS may require this documentation if the investor has to write off the losses from that debt.
Contract
When lending money to a family member, always have a contract signed that sets all of the expectations clearly. The Internal Revenue Service (IRS) may ask for copy of a signed contract to prove the loan even existed. This contract should include the loan amount, interest rate, repayment terms and list any collateral securing the loan. Additionally, you may want to list late payment and default clauses in the contract, even if you do not plan to enforce them.
Missed Payments
You should keep a detailed record of the loan's payment history. If the person you lent the money to makes the payments on a regular basis, but then begins to miss payments, this could work in your advantage if you deduct the loss and the IRS audits you. When you do not receive a loan payment on time, document your attempts to collect the debt. The IRS will only allow you to deduct the losses if you can prove it was a loan and it is uncollectable
Total Loss
If the person who you lent the money to goes out of business and cannot pay you back, then you may write off the loan as a short-term capital loss. The IRS may want proof it was a loan and not a gift. The IRS will only allow you to write this off as a non-business bad debt if you are related to the person you lent the money to. The IRS allows you to deduct the loan from your taxes in the year you determine it is a bad debt and not repayable; you do not need to wait for the entire loan term to expire prior to making this decision.
Deducting the Loss
Deducting the bad debt requires filling out a schedule D with your IRS form 1040 in claiming the debt as a short-term capital loss. You must attach a statement that describes the debt's purpose, amount and Its due date. You must also disclose your name and the business or family member you lent the money to. You must describe the efforts that you went through to collect the debt and how you determine the debt is now uncollectable. This should be included as an additional statement along with the schedule D.
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