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Bad debt and gift taxes

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MostlySerious

Junior Member
What is the name of your state? California

1) Made a $200k loan to renovate brother and sister-in-law’s large Colorado house in late 2004 for later sale in 2005. Loan secured by second deed of trust. Interest only loan payments were made during the renovation. Loan monies source from 401k via a Self-directed 401k investment custodian.

2) In 2005 house up for sale, but with real estate crash, brother and sister-in-law lost their jobs, house foreclosed and sold for less than first mortgage. I received no monies from the property sale given it was a second mortgage.

3) Brother and sister-in-law felt bad what happened and have been making small payments ever since.

4) Brother and sister-in-law divorced in 2010, but continued making separate small payments.

5) Sister-in-law just passed away and payments have stopped. She had few assets.

Questions
1) Can I claim a bad debt on my taxes this year for my sister-in-law’s remaining loan balance?

2) Based on the size of payments brother is making, he will need to live until 150 years old to pay off his share of the loan. Can I claim a bad debt on my taxes for my brother’s remaining loan balance this year if he stops making payments?

3) If I close out the loan for brother and sister-in-law through the investment custodian, will I be subject to an IRS gift tax on the $150k loan balance?
Thanks for your thoughts.
 


davew9128

Junior Member
Questions
1) Can I claim a bad debt on my taxes this year for my sister-in-law’s remaining loan balance?
No.

2) Based on the size of payments brother is making, he will need to live until 150 years old to pay off his share of the loan. Can I claim a bad debt on my taxes for my brother’s remaining loan balance this year if he stops making payments?
No

3) If I close out the loan for brother and sister-in-law through the investment custodian, will I be subject to an IRS gift tax on the $150k loan balance?
Thanks for your thoughts.
That's the kind of advice you need to pay to have researched. It's not nearly as straight forward as you think. Where the loan was made from a qualified plan, I'd be more concerned that considering this a"gift" would be a prohibited transaction and terminate the tax deferred status of the plan.
 

MostlySerious

Junior Member
Thanks davew9128 for the response. The loaning of 401k monies to siblings is not a prohibited transaction (disqualified are family members such as spouses, ancestors, lineal descendants and spouses of lineal descendants of substantial contributors, foundation managers, and 20 percent owners. Legally adopted children of an individual are the lineal descendants of the individual under this definition. IRC Section 4946 - Definition of Disqualified Person | Internal Revenue Service (irs.gov)
 

LdiJ

Senior Member
See IRS Publication 550 for more information.

A non-business bad debt is treated as a short term capital loss which is reported on Schedule D and Form 8949. Capital losses can only be deducted in annual installments of $3000.00 until the loss is used up. However, the debt must be totally worthless to be treated as a short term loss. As long as you are collecting any payments at all towards the debt, you cannot consider it to be worthless.

See a tax professional.
 

davew9128

Junior Member
Thanks LdiJ for clearing up that the loan is not worthless if one party of the loan continues to make payments.
It doesn't matter if its a bad debt or not. The plan made the loan. Qualified plans don't generally pay tax and certainly don't deduct a loss.
 

LdiJ

Senior Member
It doesn't matter if its a bad debt or not. The plan made the loan. Qualified plans don't generally pay tax and certainly don't deduct a loss.
This is true. If the plan definitely made the loan then there would be no tax attributes at all.
 

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