Discussion:Bad Debt or Capital Loss

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Discussion Forum Index --> Tax Questions --> Bad Debt or Capital Loss

Azercpa (talk|edits) said:

27 November 2005
Father was a guarantor on a $500K bank loan to his son's LLC. The LLC defaulted on the loan and the bank forced payment in full on the guarantor. The father now wants to claim the payment as a capital loss. I cannot find anything on point in my research. Can this payment be claimed as a capital loss? Would it havet to be claimed as a non-business bad debt?

If the father had an interest in the LLC would that change the answer to the above? Would an interest in the LLC be sufficient to claim this as a business bad debt?

Jamshed (talk|edits) said:

27 November 2005
If the loan is deemed to be a personal loan then the loss should be a short term capital loss. I presume the father is not in the business of lending funds and is not drawing any compensation from the LLC. Therefore to sustain a business loss may be an issue. I think you have to look to case law to see if there is an analagous situation. I think that the loss should qualify as a capital loss.
To fend of an audit i suggest attaching the guaranteed document and the payment by the father to the returns. From past experience this seems to help.

Rlw (talk|edits) said:

27 November 2005
I think the father is out of luck. Even if he could take a capital loss due to a bad debt, only the first $3,000 would be deductible in the first year. The rest would have to be carried over. But I don't think even that is deductible. Pub 550 says
Loan guarantees. If you guarantee a debt that becomes worthless, you cannot take a bad debt deduction for your payments on the debt unless you can show either that your reason for making the guarantee was to protect your investment or that you entered the guarantee transaction with a profit motive. If you make the guarantee as a favor to friends and do not receive any consideration in return, your payments are considered a gift and you cannot take a deduction.
Example 1.
Henry Lloyd, an officer and principal shareholder of the Spruce Corporation, guaranteed payment of a bank loan the corporation received. The corporation defaulted on the loan and Henry made full payment. Because he guaranteed the loan to protect his investment in the corporation, Henry can take a nonbusiness bad debt deduction.
Example 2.
Milt and John are co-workers. Milt, as a favor to John, guarantees a note at their local credit union. John does not pay the note and declares bankruptcy. Milt pays off the note. However, since he did not enter into the guarantee agreement to protect an investment or to make a profit, Milt cannot take a bad debt deduction.

If the father had an interest in the LLC, then he can take the deduction as a non-business bad debt. Pub 535 says it's not a business bad debt unless the guarantee was made as part of the father's business.

Jamshed (talk|edits) said:

27 November 2005
If this is construed to be a gift than the father has just used up $500 k of his unified credit exemption. Could the father argue that the loan guarantee payment by him was in fact a loan payable by the son to him as of the date of payment on the guarantee and if the son is unable to pay the loan back this could constitute a capital loss. I dont think that the father at any time intended this to be a gift although this could be of limited consequances.

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