Tax Court Disallows Property Dealer’s Bad Debt Deduction

If you've ever had a debt go bad, you may have believed that you could at least get a tax deduction out of the situation. But that's not always the case, as a property dealer in Maryland learned the hard way.

Claim Filing is Amiss

The taxpayer in this case had been involved for about 30 years in one or more activities involving real property, including buying, selling and renting property and providing management services for rental real property. In early April 2003, he borrowed almost $200,000 from Merrill Lynch Credit Corporation, to be repaid over 30 years. He secured the loan with a rental property.

In April, he transferred about $157,000 of the loan proceeds to another individual. That individual and his mother (the borrowers) signed a document titled "Unsecured Note." The taxpayer didn't secure the repayment in any way, such as by requiring collateral. He also never checked the borrowers' credit ratings or required them to provide financial statements. He further failed to verify the source of funds from which they would be able to comply with their loan terms.

The son made 28 monthly payments before defaulting. At that time, the monthly payments remaining totaled about $153,000. The taxpayer made oral, but not written, requests to the son for payment of the outstanding debt. He never asked the mother to pay all or part of the debt and pursued no legal remedy.

In October 2006, the son filed for bankruptcy. The taxpayer, however, didn't file a claim regarding the outstanding debt. On his 2009 Form 1040, the taxpayer identified his principal business or profession as "property management." He claimed a deduction for the loss on the loan. The IRS disallowed the deduction, and the case ended up in the U.S. Tax Court.

The Tax Court Weighs In

The taxpayer asserted that he was entitled to deduct the entire amount of the alleged outstanding debt as a business bad debt because he was in the business of lending money. Business bad debts are generally considered ordinary losses that can be offset immediately against ordinary income.

For all or part of a debt to be deductible as a business bad debt, the debt must be either:

• Created or acquired in connection with a trade or business, or
• Incurred in the taxpayer's trade or business.

The fact that a taxpayer makes a loan for the sole purpose of obtaining interest income doesn't, standing alone, satisfy this requirement.

Moreover, for a taxpayer to be entitled to a bad debt deduction in connection with the business of lending money, the taxpayer's lending activity must be "so extensive and continuous as to elevate that activity to the status of a separate business." During his 30 years in the property business, though, the taxpayer made loans on about six different occasions. He also never advertised himself as a money lender or kept a separate office or books and records relating to any of the loans.

The Tax Court found that the taxpayer didn't establish that his lending constituted a separate business. Notably, it also pointed out that, in a previous case, the court had held that making eight or nine loans in the course of four years didn't elevate the lending activity to the status of a separate business.

Don't Take The Deduction for Granted

Unless you engage in enough lending activity to establish a separate business, you'll be able to claim a business bad debt deduction only on loans that are connected to your business. Consult with your financial advisor to determine the best way to increase your odds of securing the deduction.

Don't Overlook The Personal Bad Debt Deduction

If you find yourself with a bad debt that doesn't qualify for the business bad debt deduction, you may qualify for the nonbusiness bad debt deduction. A nonbusiness bad debt is basically any debt that doesn't qualify as business debt.

Unfortunately, nonbusiness bad debts receive less favorable tax treatment than business bad debts. Rather than being treated as immediately deductible ordinary losses, they're deductible as a short-term capital loss and only in the year the debt becomes totally worthless. "Totally worthless" means there's no reasonable expectation of payment. In such cases, the deduction can be used to offset capital gains. If a net capital loss results, the taxpayer can use it to offset up to $3,000 ($1,500 if married and filing separately) of other income. Any balance remaining will be carried over as a short-term capital loss.

The court in the Langert v. Commissioner of Internal Revenue case (see main article) found the taxpayer couldn't use this deduction, though. He failed to show any events that established the debt was totally worthless.

For more information, contact Doug Collins, our real estate partner at (973) 328-1825.