Dear TaxGuru,

I extended a loan tof $15,000 one of my friends last year for his business. Unfortunately, my friends business went bankrupt!

I was wondering can I at least write off these bad debts on my 2006 tax return? My friend is completely broke and has filed for bankruptcy..It appears that this loan is not collectible. Pretty soon he will be getting a judgement against him from a Bank, so I am last in line w/o any recourse.!

Also, if these losses are deductible, how does one go about claiming this losses and what proof or requirements do I need to submit to the IRS?

If your friend who owes you money that you cannot collect, you have what is known a non-business bad debt. Non-business bad debts must be totally worthless to be deductible. You cannot deduct a partially worthless non-business bad debt.

The IRS requires that you must establish that you have taken reasonable steps to collect the debt and that the debt is worthless. It is not necessary to go to court if you can show that a judgment from the court would be uncollectible. You may take the deduction only in the year the debt becomes worthless. A debt is demed worthless when the facts and circumstances indicate there is no longer any chance the amount owed will be paid. You do not have to wait until the debt comes due. A judgement obtained against a debtor is considered to be sufficient to demonstrate that reasonable steps have been made to collect the debt.

A non-business bad debt is reported on Form 1040, Schedule D, Capital Gains and Losses, as a short-term capital loss. It is subject to the capital loss limit of $3,000 per year. This limit is $1,500 if you are married filing a separate return. A non-business bad debt requires a separate detailed statement attached to the schedule D.

The following are expressly required to be included in the statement as follows:

1. Your relationship to the debtor
2. Name and address of the debtor
3. The amount and date of the original loans made
4. Efforts made to collect this loan
5 .What basis has a determination been made to consider it to be worthless

For more information on non-business bad debts, refer to Publication 550.

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