Bad Debt or Loss on Investment?

I am interested in what develops in this thread. It seems that the original debt was redeemed for less than your basis, and thus you have a capital loss. So, if you made the original loan for $1,000, it was redeemed for $450 cash and $250 new note. Your capital loss would be $300.

The rule that the security must be totally worthless means, I suppose, that if the original loan was still being paid on, even at a small pace, you would have to wait until the possibility of further payments completely ceased to write off any remaining basis.

Any other thoughts out there? If one finds themselves with a bad debt that is not totally worthless, is this type of restructuring the way to go to get some tax benefit at the present time?

... snipped to shorten the posting...

==> The rule that the security must be totally worthless means, I suppose, that ==> if the original loan was still being paid on, even at a small pace, you ==> would have to wait until the possibility of further payments completely ==> ceased to write off any remaining basis.

Aye, there's the rub (see ==> just above). It would seem that, if viewed as a "non-business bad debt" it must be totally worthless for individuals:

From Sec. 1.166-5(a)(2) Nonbusiness debts: "A loss on a nonbusiness debt shall be treated as sustained only if and when the debt has become totally worthless, and no deduction shall be allowed for a nonbusiness debt which is recoverable in part during the taxable year."

In the case of Buchanan v US, 87 F.3d 197, judge Posner stated: "The Internal Revenue Code allows the deduction of a nonbusiness debt that "becomes worthless within the taxable year," 26 U.S.C. §

166(d)(1)(B). The criterion of worthlessness is interpreted strictly: the deduction is unavailable if even a modest fraction of the debt can be recovered. Treas. Reg. § 1.166-5(a)(2) ("wholly worthless"); Bodzy v. Commissioner, 321 F.2d 331, 335 (5th Cir. 1963) ("last vestige of value" must have "disappeared"); Clanton v. Commissioner, 70 Tax Ct. Mem. Dec. (CCH) 534 (1995) ("partial worthlessness is insufficient"). The reason for this hard line is plain. Because people rarely make nonbusiness loans to strangers, or even to friends, the domain of the nonbusiness debt is limited largely to the family."

To drive the point home, he further stated: "The taxpayers wisely do not argue that so much of their nonbusiness debt as has not been repaid and is unlikely to be repaid, which is to say $ 2.1 million minus the $ 480,000 that, as best we can estimate, will be their total recovery, will be deductible in the tax year in which the hope of further recovery is finally extinguished. Such an approach, in which the unpaid balance of a partially recovered debt is severed from the original unpaid balance and characterized as a separate, totally worthless debt, would defeat the requirement of showing complete (well, nearly complete, for the reason explained earlier) worthlessness."

Judge Posner's full opinion and case details can be found at

That's why I'm wondering if the nature of the transaction can be characterized as a loss on investment rather than a bad debt. Any references to rulings (Tax Court or other) or regulations would be greatly appreciated.

No difference in treatment. Both ways, the deduction would be limited by capital loss rules to $3k/year beyond any capital gains.

No. The original note wasn't worthless.

what was the nature of your original investment? was it a loan, or an equity interest?

Also, I have to wonder: even if it was a loan, were you not "in the business" of making this type of loan? I'd like to see more case law, as the case you cited was not really at all like your situation.

On Sun, 10 Feb 2008 00:31:59 EST, "Gil Faver" the case you cited was not really at all like your situation.

Thanks for the reply.

The original investment was a loan (unsecured promissory note), definitely not an equity interest.

According to the reading we've been able to do we would *not* be considered in the business of making this type of loan. It was a one-time arrangement. Never done it before, and needless to say, never will do it again.

It's true the case law cited isn't really like our situation. The cases we were able to find pertained to either (a) inter-family loan arrangements or (b) business related loans. We're sort-of caught in the middle. Unfortunately the law and regulations are unequivocal about non-business bad debts having to be "totally worthless" in cases like this. The court cases explain the rationale as disallowing "shady" deals between family or friends to reduce taxes. Surprisingly, we couldn't find any cases similar to our own situation. Strange, considering how many news stories one hears about financial advisors messing with client accounts...

My thinking is that you are in the business of making investments.

And, if I sell one hamburger, I am in the business of selling hamburgers. Of course, that is just my opinion at this point.

)snopped...._

Just one hamburger? Naw...... that's a hobby! (grin

ChEAr$, Harlan Lunsford, EA n LA