Overview
Lending money to a child or other relative is a common way to help with a home purchase, start a business, cover unexpected costs, or get through a tough financial stretch. When the borrower cannot repay, you may wonder whether the unpaid amount can be written off on your tax return. The IRS allows a deduction for a non‑business bad debt only if the loan was a genuine debtor‑creditor relationship and the debt later becomes completely worthless.
Key Takeaways
A loan to a family member may qualify as a non‑business bad debt if it was a legitimate loan with a clear expectation of repayment, not merely a gift.
The debt must be totally worthless before you can claim a deduction; you cannot deduct only the portion you think will not be repaid.
Strong documentation—such as a written loan agreement, repayment schedule, payment records, and collection attempts—helps prove the transaction was intended as a loan.
IRS Requirements for a Non‑Business Bad Debt
Intent to Repay
At the time the money was transferred, both you and the borrower must have understood that repayment was expected. A promissory note or written loan agreement provides strong evidence of this intent. The agreement should ideally include the loan amount, repayment schedule, interest rate (if any), due date, and consequences of missed payments.
Interest‑free or below‑market family loans can trigger additional tax rules. The IRS may require you to recognize forgone interest as income under the below‑market loan provisions.
Debt Must Be Completely Worthless
You may claim a bad‑debt deduction only when the debt has no reasonable chance of being repaid. Indicators of worthlessness include the borrower’s bankruptcy, prolonged insolvency, or unsuccessful collection efforts. You do not need to obtain a court judgment if you can show that a judgment would be uncollectible, but you should be able to demonstrate reasonable collection attempts.
Basis in the Debt
To deduct a bad debt you must have a tax basis in the amount loaned—typically the cash you actually provided. You cannot claim a deduction for money that was never included in your income or that you never actually lent. The IRS also notes that funds given to a minor child for basic living expenses do not create a bona fide debt for bad‑debt purposes.
How the Tax Write‑Off Works
If the loan satisfies the IRS criteria and becomes totally worthless, the loss is treated as a short‑term capital loss, regardless of how long the debt was outstanding. You report it on Form 8949, Sales and Other Dispositions of Capital Assets, and the amount flows to Schedule D. On Form 8949 you must identify the debtor and note that a bad‑debt statement is attached.
The attached statement should contain:
- A description of the debt, including the amount and original due date
- The borrower’s name and your family relationship
- Steps you took to collect the money
- An explanation of why you concluded the debt is worthless
Because it is a capital loss, the deduction is subject to the usual capital‑loss limits; the full loan amount does not necessarily reduce your taxable income dollar‑for‑dollar in the year of the loss.
Example
Imagine you lend your adult daughter $20,000 under a written agreement calling for monthly payments. She makes payments for a while, then encounters serious financial trouble. After reasonable collection attempts she files for bankruptcy, and the facts show no realistic chance of recovering the remaining $15,000 balance. If the loan qualifies as a bona fide debt and becomes completely worthless during the tax year, the $15,000 could be claimed as a non‑business bad debt and reported as a short‑term capital loss.
Had you originally told her to “pay it back whenever you can” with no firm repayment expectation, the IRS would likely view the transfer as a gift, which cannot be deducted as a bad debt.
What to Do If You Didn’t Get It in Writing
Many family loans are informal, lacking a written promissory note. Without a written agreement, establishing a bona fide debt is more challenging, but the central question remains whether a true debtor‑creditor relationship existed. You can gather other evidence to show the parties’ intent, such as:
- Bank records showing the original transfer
- Emails or text messages discussing the loan
- Records of any payments made by the borrower
- Messages referencing repayment dates or amounts
- Evidence that you requested repayment
- Documentation of the outstanding balance
- Communications in which the borrower acknowledges owing you money
Creating a loan agreement after the fact and treating it as if it existed from the start is not advisable; such retroactive documentation does not convert a genuine gift into a loan. Because family transactions receive extra scrutiny, consulting a tax professional before claiming a large non‑business bad debt without formal paperwork is wise.
Frequently Asked Questions
Can I deduct money I loaned to my child if they don’t pay me back?
Potentially, if the transfer was a legitimate loan with a genuine expectation of repayment and the debt later becomes completely worthless. You must be able to show a bona fide debtor‑creditor relationship and an obligation to repay.
Is a loan to a family member considered a gift?
Not automatically. A loan with a real expectation and enforceable obligation to repay remains a loan. If you provided the money without any realistic expectation of repayment, the IRS may treat it as a gift, which cannot be deducted as a bad debt.
Does a family loan have to be in writing?
The IRS looks for evidence of a genuine debt and enforceable repayment obligation. While not strictly required, a written promissory note or loan agreement makes it much easier to demonstrate that the transaction was intended as a loan rather than a gift.
Do I have to charge my child interest on a loan?
Family loans can be subject to the below‑market loan rules. If you charge no interest or a rate below the applicable federal rate, the IRS may impute interest, requiring you to report that amount as income. The IRS publishes the applicable federal rates monthly.
Can I deduct part of a family loan if I think I’ll recover some of it?
Generally, no. A non‑business bad debt must be totally worthless before it is deductible. The IRS does not allow a deduction for a debt that is only partially uncollectible.
When can I claim the bad debt deduction?
You claim the deduction for the tax year in which the debt becomes worthless. The exact timing depends on the facts and circumstances, such as the borrower’s bankruptcy or prolonged insolvency.
Do I have to take my child to court before writing off the loan?
Not necessarily. The IRS states you do not need to obtain a judgment if you can show that a judgment would be uncollectible. However, you should be able to demonstrate that you made reasonable collection efforts.
What happens if my child eventually repays me after I claimed the deduction?
If you later recover some or all of the amount you previously deducted as a bad debt, the recovered portion may need to be included in your gross income to the extent the earlier deduction provided a tax benefit.
Can I simply forgive the loan and claim a deduction?
No. Forgiving a loan is not the same as the debt becoming worthless. Forgiveness can also trigger gift‑tax consequences. The IRS notes that gift‑tax rules may apply to debt forgiveness as well as certain interest‑free or below‑market loans.
Final Thoughts
Writing off an unpaid loan to a child is possible, but you must do more than label the money a “loan.” You need to show that a genuine debtor‑creditor relationship existed, that there was a clear expectation of repayment, and that the debt later became completely worthless. Proper documentation from the outset—such as a written agreement, payment records, and evidence of collection attempts—greatly strengthens your position. Because family loans can raise additional tax issues, especially when large sums or below‑market interest rates are involved, seeking advice from a qualified tax professional can help ensure you treat the transaction correctly and avoid unexpected tax consequences.
