Non-business Bad Debt Deduction
The act of lending to a family member, friend or other party does not qualify as a tax deduction in and of itself. Money lent to a family member is only tax deductible as a non-business bad debt if the loan goes unpaid. The Internal Revenue Service says that a loan is only considered a tax deductible bad debt if it is totally worthless, meaning there is no chance that the borrower will pay back the loan in the future. If you lend $50,000 to your child to help pay for a home and the child makes irregular payments to you on the debt, it is not a tax deductible bad debt because you are still being paid back.
Loans vs. Gifts
The IRS draws a distinction between loans and gifts; a loan is an amount given to another person with the expectation that it will be repaid. If you lend money to a friend or family member with the understanding that it might not be repaid, it is considered a gift rather than a loan. Gifts are not tax deductible. In addition, money borrowed by minor children to pay for their basic needs is not considered a genuine debt and you cannot take a bad debt deduction on such a loan.
When Bad Debt Deductions Apply
The IRS states that bad debt deductions must be claimed in the year that the debt became worthless. Bankruptcy of the debtor is generally considered good evidence that a debt is worthless and that debt may be tax deductible.
Considerations
Lending to family members who are unable to get loans from banks is a risky practice. If a bank denies a loan, it means that the borrower presents a substantial risk of default. By lending to such a person, you take on a risk that commercial lender was not willing to accept. Even if you are able to deduct a bad loan, you end up losing money.
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