At 66, He Loans an Old Friend $25,000 and May Never Recover It. The IRS Allows a Deduction, but Only as a Capital Loss

Dan’s former roommate stopped replying, and the $25,000 he lent may be gone for good. Tax law does offer a possible write-off, but it depends on a key document he may not have and on getting the timing right.

A year after Dan wrote a $25,000 check to his old college roommate, the texts dried up. The calls began going to voicemail. Dan, who is 66 and fully retired, is gradually coming to terms with the possibility that the money will never be repaid.

This kind of situation is not unusual. A long-ago tax column from the Orlando Sentinel explained what happens when a personal loan to a friend turns sour. The basic rule still applies: the IRS allows a deduction only when there is no reasonable chance the loan will be repaid.

The complication for Dan is that a failed personal loan is treated as a nonbusiness bad debt. Under the tax code, that loss is handled like a capital loss on an asset held for no more than one year. In practical terms, it is treated much like a stock sold at a loss, with the same annual limits attached.

Two Requirements Dan Must Meet Before Taking a Deduction

First, the arrangement must truly be a loan. IRS Publication 550 says a debt exists only when there is a valid, enforceable duty to repay a fixed or determinable amount. If money is given to a friend with the understanding that it might never come back, the IRS can treat it as a gift rather than a loan. Gifts are not deductible.

Second, the debt must be completely worthless. A partially worthless nonbusiness debt does not qualify. So if the borrower makes a small payment or still promises to pay later, Dan would need to wait.

What Makes a Friendly Favor Count as a Loan

Treasury rules make the distinction clear: a gift is not a debt. The burden is on Dan to show otherwise. The strongest evidence would be a signed promissory note laying out the amount borrowed, any interest rate, the repayment schedule, and what happens if the borrower defaults, along with records showing he asked to be repaid.

Loans to family members can also trigger below-market interest rules under the tax code, a topic often discussed in connection with intra-family lending.

How the $25,000 Loss Is Applied

Capital losses are first used to offset capital gains. After that, only up to $3,000 a year can be deducted against ordinary income such as pension payments or IRA withdrawals, or $1,500 if married filing separately. Any remaining loss carries forward to later years and keeps its short-term character.

Scenario 1: No capital gains. Dan could deduct $3,000 each year for eight years, then claim the final $1,000 in the ninth year. It is slow, but the deduction would still be valuable.

Scenario 2: Offset it with gains. If Dan sells appreciated stock and realizes $15,000 in gains, the bad debt would erase those gains, reduce another $3,000 of ordinary income, and leave $7,000 to carry forward. That remaining amount would be used over the next two years at $3,000 per year, with the final $1,000 deducted in the following year. If he had $22,000 or more in gains, the entire loss could be absorbed in one year.

For many retirees with taxable brokerage accounts, the second approach is often more useful. If Dan was already planning to rebalance or sell appreciated shares, doing so in the year the debt becomes worthless can turn a long carryforward into an immediate offset.

How to Report It Correctly

The loss is reported on Form 8949, Part I, with box C checked. In column (a), Dan would list the debtor’s name and note that a bad debt statement is attached. Column (e) should show his basis, and column (d) should be zero. The totals then carry over to Schedule D.

The attached statement should include:

1. The debt itself: a description of the obligation, including the amount and the date it became due.
2. The borrower: the debtor’s name and any business or family relationship between them.
3. Collection efforts: calls, letters, emails, or other proof that he tried to collect.
4. Why it is worthless: for example, the borrower filed bankruptcy or legal action would likely recover nothing.

Timing is also crucial. The deduction belongs in the year the debt became worthless. If Dan uses the wrong year, he may have up to seven years rather than the usual three to file an amended return under 26 U.S.C. § 6511(d)(1).

Before Writing the Next Check

The safest rule is simple: only lend money you can afford to lose completely. If repayment seems doubtful from the outset, treating it as a gift may be the cleaner choice. For 2026, the annual gift tax exclusion is $19,000 per recipient. Dan could give that amount directly, avoid the paperwork, and not pretend the money is a loan.

Why One Signed Document Matters So Much

Dan’s first task is to figure out whether he has the paper trail needed to support a deduction. Without a written note, an interest rate, and proof that he asked for repayment, the IRS could classify the transfer as a gift and deny the write-off.

The other error to avoid is claiming the deduction too soon. As long as the borrower is still making occasional payments or offering promises, the debt is not yet fully worthless.

In the end, the deduction may come down to a single piece of paper: a promissory note, signed by both parties before the money was handed over.