At 66 He’ll Lend an Old Friend $25,000 and Never See It Again. The IRS Lets Him Deduct It, but Only as a Capital Loss

A year after Dan handed his old college roommate a check for $25,000, the texts stopped. Then the calls started going to voicemail. Dan is 66, comfortably retired, and slowly accepting that the money is gone.

This is a familiar scenario. Back in 1992 the Orlando Sentinel ran a column on what to expect at tax time when a loan to a friend goes bad. Its core point still holds: the IRS lets you deduct a worthless loan only if there’s no likelihood of getting paid back.

Here’s the catch Dan didn’t see coming. A personal loan that goes bad is called a nonbusiness bad debt. The tax code handles it as a loss on a capital asset held for not more than 1 year, under 26 U.S.C. § 166(d)(1)(B). In plain English, it lands in the same category as a stock sold at a loss, and that category comes with a annual cap.

Two Tests Dan Has to Pass Before Any Write-Off

First, it has to be a real loan. IRS Publication 550 says a debt is genuine only if there’s a valid and enforceable obligation to repay a fixed or determinable sum of money. If you lend to a friend “with the understanding that it may not be repaid, it is considered a gift and not a loan.” Gifts aren’t deductible.

Second, the debt has to be totally worthless. You can’t deduct a partly worthless nonbusiness debt. So if his friend sends a small payment and promises more, Dan waits.

What Turns a Favor Into a Loan the IRS Will Accept

Treasury regulations say clearly that a gift shall not be considered a debt. The proof is on Dan. The strongest evidence is a signed promissory note that spells out the loan amount, interest rate, repayment schedule, and consequences of default, plus a paper trail of him asking for the money back.

Loans to relatives also come with interest-rate rules under the tax code’s below-market loan provisions, which we’ve covered in our look at intra-family loans.

How a $25,000 Loss Actually Gets Used

Capital losses first wipe out capital gains. After that, you can deduct only $3,000 ($1,500 if married filing separately) a year against ordinary income like pensions or IRA withdrawals. Anything left over carries over to the next year and keeps its short-term character.

Path 1: No capital gains. Dan deducts $3,000 a year for eight years. The last $1,000 comes off in year nine. It’s slow, but it’s real.

Path 2: Pair it with gains. Say Dan cuts an old stock position this year and realizes $15,000 in gains. The bad debt wipes out those gains, reduces $3,000 off his ordinary income, and leaves $7,000 to carry forward. That’s used up over the next two years at $3,000 each, with the final $1,000 in the year after. Gains of $22,000 or more would soak up the whole loss in a single year.

For most retirees with a taxable brokerage account, Path 2 is the better move. If Dan was going to rebalance or sell appreciated shares anyway, doing it in the year the debt goes bad turns a nine-year spread into an immediate offset.

Filing It Right So It Survives an Audit

The loss goes on Form 8949, Part I, with box C checked. In column (a), he records the debtor’s name and “bad debt statement attached,” his basis in column (e), and zero in column (d). The totals flow to Schedule D.

The attached statement must include:

1. The debt itself: a description, including the amount and the date it became due.
2. Who owes it: the debtor’s name and any business or family relationship between them.
3. Collection efforts: calls, letters, emails, anything showing he actually tried to get paid.
4. Why it’s worthless: for example, the borrower declared bankruptcy, or legal action probably wouldn’t recover any of it.

Timing matters too. The deduction belongs in the year the debt became worthless. If Dan picks the wrong year, he gets 7 years instead of the usual three to file an amended return, under 26 U.S.C. § 6511(d)(1). Quiet rules like this one are the kind of thing that drains retirement accounts without anyone noticing, which is why we mapped out nine of them in a free guide to the traps retirees most often walk into.

Before He Writes the Next Check

The clearest rule: lend only what you’d be fine never seeing again. If repayment feels unlikely from day one, make it a gift instead. For 2026, the annual exclusion for gifts remains at $19,000 per recipient. Dan could give that much outright, keep things simple, and skip pretending it’s a loan.

One Signed Page Decides Whether This Is Deductible

Before anything else, Dan needs to find out whether he has paper. Without a written note, an interest rate, and proof he asked for repayment, the IRS can call this a gift, and the deduction disappears.

The mistake to avoid is writing the loan off too early. While the friend is still making occasional payments or promises, the debt isn’t totally worthless yet.

Next time, the whole deduction comes down to a single sheet of paper: a promissory note, signed by both of them, before the money changes hands.

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