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Author: JAFO31 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121572  
Subject: Re: Collateral taken Date: 9/2/2011 4:40 PM
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ncredbear: <<<With the economic climate, I placed $20,000 in a CD that I pledged as collateral for a bank loan for my brother and his partner's business. This was 3 years ago. The businees continued to suffer and they were unable to keep up the loan payments. 2 months ago the bank took about $15,000 of the CD to cover the loan. Can I show this as a loss on my taxes? If so what is the proper way to do so? This assumes my brother and partner do not repay me any of the money, which I doubt will happen anytime in the next several years, if at all.>>>

ptheland: "Sounds like a non-business bad debt. On your tax return, it is reported as a short-term capital loss. There's an additional statement you need to attach to your tax return when claiming a non-business bad debt. Publication 550 has the details on that statement. http://www.irs.gov/publications/p550/index.html "

Peter - our link confused me.

First it contains the following text:

"Deductible nonbusiness bad debts. To be deductible, nonbusiness bad debts must be totally worthless. You cannot deduct a partly worthless nonbusiness debt.

Genuine debt required. A debt must be genuine for you to deduct a loss. A debt is genuine if it arises from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum of money.

Loan or gift. For a bad debt, you must show there was an intention at the time of the transaction to make a loan and not a gift. If you lend money to a relative or friend with the understanding that it may not be repaid, it is considered a gift and not a loan. You cannot take a bad debt deduction for a gift. There cannot be a bad debt unless there is a true creditor-debtor relationship between you and the person or organization that owes you the money.

Op did not mention any written agreement between OP and his broether and brother's partner. Is the common law right of subrogation sufficient to establish a creditor-debtor relationship?

"When deductible. You can take a bad debt deduction only in the year the debt becomes worthless. You do not have to wait until a debt is due to determine whether it is worthless. A debt becomes worthless when there is no longer any chance that the amount owed will be paid."

Op said he was doubtful, not that he was certain he would not be repaid.

<<<You must only show that you have taken reasonable steps to collect the debt. Bankruptcy of your debtor is generally good evidence of the worthlessness of at least a part of an unsecured and unpreferred debt.>>>

OP did not mention any steps to collect on the debt.

"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."

It seems to me that pledging collateral is akin to a guaranty, at least as to the value of the collateral.

"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."

That example sounds like the OP, from the little we have read.

"Rights against the borrower. When you make payment on a loan you guaranteed, you may have the right to take the place of the lender (the right of subrogation). The debt is then owed to you. If you have this right or some other right to demand payment from the borrower, you cannot take a bad debt deduction until these rights become totally worthless."

See above. Doubtful v. totally worthless.

I assume that the following is the "additional statement" you referenced?

"How to report bad debts. Deduct nonbusiness bad debts as short-term capital losses on Schedule D (Form 1040).

On Schedule D, Part I, line 1, enter the name of the debtor and “statement attached” in column (a). Enter the amount of the bad debt in parentheses in column (f). Use a separate line for each bad debt.

For each bad debt, attach a statement to your return that contains:

A description of the debt, including the amount, and the date it became due;

The name of the debtor, and any business or family relationship between you and the debtor;

The efforts you made to collect the debt; and

Why you decided the debt was worthless. For example, you could show that the borrower has declared bankruptcy, or that legal action to collect would probably not result in payment of any part of the debt."

Curiously, JAFO
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