Question

Milly loaned her friend, Frank, $3,500 on July 1st two years ago. At the inception of the loan arrangement, Frank signed a promissory note. He has repaid $500 of the loan. On

September 1st of the current year he declared bankruptcy. Frank told Milly that he will be unable to make any further payments on the loan. No Form 1099 was issued for the

outstanding balance.

1. How is this reflected in regards to AGI and taxable income?

Milly owns and operates Office Administration Services as a sole proprietor. She is a cash basis taxpayer. She is a material participant in the business. She is not required to file any Forms 1099 for the business. Milly had the following income and expenses from the business:

a. Gross Receipts $18,000

b. Office expenses $1,000

c. Rents $8,000

d. Supplies $2,000

e. Payroll taxes $600

f. Utilities $4,000

g. Wages $6,000

h. Estimated Federal income tax payments $1,200

2. How is this reflected in regards to AGI and taxable income?

Answer 1

Since,multiple case studies have been posted and each case study is independent of another, I have answered the first one with complete details.

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Part 1)

As per the applicable rules, the amount of loan extended to a friend or a relative cannot qualify as a business debt. It would, therefore be treated as a "Nonbusiness Debt". Failure of the borrower to repay the loan would result in the creation of a "Nonbusiness bad debt". A short term capital loss can be reported by the lender if the borrower has defaulted on the entire amount of the loan. Such a short term capital loss can first be adjusted against short term capital gain and thereafter against long term capital again and regular income upto a maximum value of $3,000 (if any amount of loss is left after adjusting short term and long term capital gain). The balance amount of short term capital loss after all adjustments can be carried forward to subsequent years. However, if any amount of partial recovery (against the loan) has been made, the lender is not allowed to claim any amount of nonbusiness debt as short term capital loss.  

In the given case, Frank had repaid $500 to Milly which resulted in partial recovery of the loan amount. Therefore, even though the non-repayment of loan money by Frank would get qualified as "Nonbusiness bad debt", Milly won't be able to report short term capital loss on her tax return and claim a deduction for the same as per applicable rules and regulations.

The amount of $3,000 (3,500-500) will have no effect on AGI and taxable income.